Estate Planning With a 721 Exchange: The Step-Up Advantage

The 721 exchange is usually explained as a way to trade a property for a diversified REIT position while deferring tax. But for a large share of the investors who use it, the deeper purpose is the estate plan — and on that front the 721 has two distinctive strengths: it can convert a lifetime of deferred gain into gain that is largely eliminated for heirs, and it leaves behind an asset that divides among beneficiaries far more gracefully than a building ever could. This memo examines the 721 through the estate-planning lens, including the cautions that keep the strategy honest.

The core idea: deferral that can become elimination

A 721 exchange defers tax, like a 1031. The estate-planning insight is what can happen to that deferred tax at the end of a life. Under current law, assets generally receive a step-up in basis to fair market value at the owner's death. For an investor who has deferred a large gain into OP units and holds them until death, that step-up can eliminate the deferred capital gain and depreciation recapture entirely — the income tax that was merely postponed during life simply disappears for the heirs.

This turns the 721 from a deferral tool into something closer to a forgiveness tool, provided the units are held for life. It's the same logic that makes serial 1031 exchanges so powerful, applied to a vehicle that's diversified and easy to pass on. For an investor whose primary goal is transferring wealth efficiently rather than spending it, that's a compelling endgame.

How the step-up in basis works

During your lifetime, your basis in the OP units carries the low, deferred figure from the property you originally contributed — which is why converting or selling the units triggers tax. At death, however, the basis is generally reset to the units' fair market value as of that date. Your heirs inherit the units at this stepped-up basis, so if they then convert to REIT shares or sell, they recognize little or no gain, because their basis is the current value rather than your old one.

In effect, the deferred income-tax liability you carried for years is wiped clean at the generational handoff. The heirs receive a diversified, near-liquid asset with a fresh basis, free of the embedded gain that would have taxed you heavily had you cashed out during life.

"Swap till you drop," applied to the UPREIT

Real estate investors have long described the strategy of deferring through successive 1031 exchanges and holding until death as "swap till you drop." The 721 offers a clean final resting place for that strategy. An investor can 1031 from property to property (or through DSTs) for decades, then take a 721 into a REIT for the last leg — gaining diversification and ease of transfer — and hold the OP units for life. The deferral that began with the first exchange ends not in a tax bill but in a step-up.

The advantage of finishing in OP units rather than a directly owned building is everything that follows below: divisibility, liquidity for the estate, and passive income in the meantime. The 721 is, for many, the graceful conclusion to a lifetime of 1031s.

Divisibility: OP units versus a single building

Consider the practical problem of leaving a single apartment building to three children. One property, three heirs — someone has to manage it, they may disagree about whether to hold or sell, and dividing it cleanly is nearly impossible without selling. Real estate is famously hard to split, and the result is often forced sales or family friction.

OP units solve this elegantly. Units are fungible and divisible — you can leave a precise number to each heir, exactly as you would shares of stock. Each heir then independently decides whether to hold for income, convert to shares, or redeem for cash, without being yoked to siblings or to a property no one wants to manage. For families with multiple beneficiaries, this divisibility is frequently the deciding advantage of finishing in a 721 rather than holding the building.

Liquidity for the estate

Estates have bills — taxes, debts, equalizing bequests — and illiquid real estate can force a hurried sale to pay them. Because inherited OP units carry a stepped-up basis, heirs can convert them to REIT shares or redeem them for cash with little or no income-tax cost, turning an otherwise illiquid legacy into spendable funds when needed. That flexibility can be invaluable for settling an estate, funding a charitable gift, or simply giving heirs options a single building wouldn't. The same step-up that eliminates the deferred gain also makes the asset genuinely usable for the next generation.

Income for the owner's lifetime

None of the estate benefits require sacrificing income along the way. While you hold the OP units, they pay distributions that track the REIT's dividend — passive cash flow from a diversified portfolio, with no management on your part. So the 721 estate strategy isn't about denying yourself; it's about living on the income during your lifetime while positioning the underlying asset to pass efficiently at death. For a retiree who wants reliable income now and an efficient transfer later, that combination is much of the appeal.

Cautions and what to confirm with counsel

Several caveats keep this strategy grounded. First, the income-tax step-up is distinct from estate tax: the units remain part of your taxable estate, so a large estate may still face estate tax even as the income-tax gain is eliminated — two different taxes that must be planned for separately. Second, you must actually hold the units until death for the step-up to apply; converting or selling during life forfeits it for the converted portion. Third, the rules governing basis step-up and estate tax are intricate and have changed before; a strategy built on today's law should be reviewed as laws evolve.

Finally, not all OP units or REIT structures are identical, and the protections and conversion terms in the partnership agreement matter. This is emphatically a strategy to design with a qualified estate attorney and tax advisor, not to assume from a general article. Our estate-planning guide places the 721 within the broader toolkit.

A worked example

Consider an illustrative investor who, late in life, completes a 721 exchange and holds OP units paying steady distributions. (Figures hypothetical.) She has a large deferred gain embedded in the units from decades of 1031s. Rather than convert — which would trigger that gain — she lives on the distributions and holds the units. At her death, the units pass to her two children with a basis stepped up to current value. The children divide the units evenly; one keeps them for income, the other converts to REIT shares and sells to fund a home purchase, each owing little income tax because of the step-up. The gain their mother deferred for thirty years is never taxed. The 721 did exactly what the estate plan intended: income for her, an efficient and divisible transfer for them, and elimination rather than mere deferral of the embedded gain. As always, the specifics belong with qualified counsel.

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