OP Units and Tax-Deferred Property Contributions

Introduction

A property owner who sells a fully depreciated building for cash can lose a third or more of the proceeds to federal and state tax before the wire even clears. The same owner who contributes that building to an UPREIT operating partnership in exchange for OP units under Section 721 of the Internal Revenue Code pays nothing at closing. That single difference is why OP units exist, and why they keep appearing as deal consideration when a REIT wants a property whose owner refuses to take a taxable cash exit.

The deferral is not a loophole that closes later on its own. It persists for as long as the units are held. Conversion to REIT common shares or cash redemption triggers the deferred tax at that later moment, and a contributor who holds the units until death can erase the cumulative gain entirely through the Section 1014 step-up in basis. OP units therefore show up wherever a contributor's tax position is doing the negotiating: REIT M&A, where they serve as tax-deferred merger consideration; REIT IPO formations, where founders roll property in for units rather than sell; and REIT-led acquisitions, where a seller takes units instead of cash to keep the gain locked away.

A Section 721 contribution is the moment when a property owner transfers real estate into an UPREIT operating partnership in exchange for OP units. The mechanics:

Section 721 Contribution

A tax-deferred transfer of real estate to a partnership in exchange for partnership interests under IRC Section 721. The contributor's basis in the partnership units equals the contributor's basis in the contributed property (carryover basis), and no current-year gain or loss is recognized at the contribution. Section 721 is the foundational tax mechanism that makes the UPREIT structure work; without it, property contributors would face immediate gain recognition on every contribution and the OP unit mechanic would be economically uninteresting.

Basis Carryover and Built-In Gain

The carryover basis treatment is the core of the Section 721 economics. A contributor with a fully depreciated $10 million building (basis approximately $2 million after years of depreciation) who contributes the building for $10 million worth of OP units receives OP units with $2 million of tax basis, not $10 million. The $8 million of built-in gain (the difference between FMV and basis at contribution) is preserved in the OP units and will be recognized when the units are eventually redeemed or converted.

The carryover-basis treatment also means depreciation recapture is preserved. The contributor's accumulated depreciation on the original property carries forward and is taxed at the depreciation-recapture rate (currently 25% federal) when the OP units are converted or redeemed. That detail matters more than it first appears: recapture is taxed at a higher rate than the long-term capital gain itself (typically 20% federal plus state), so deferring it is worth more per dollar than deferring ordinary appreciation. A 1031 like-kind exchange defers the same gain, but it forces the owner back into directly held real property; the 721 route hands them a liquid, diversified, dividend-paying interest in a public REIT instead.

OP unit lock-up structures vary by REIT and by transaction. The standard mechanism includes:

OP Units (Operating Partnership Units)

Limited partnership interests in the operating partnership of an UPREIT structure, received by property contributors in exchange for property under Section 721 with a carryover basis. OP units receive the same per-unit cash distribution as REIT common shares and are typically convertible into REIT common shares on a 1:1 ratio after a defined lock-up period (often 12 months minimum, with separate negotiated lock-ups of 2-5 years for major contributions).

The lock-up is itself a negotiating lever. A REIT seeking to secure a major sponsor or family-office contribution may offer higher OP-unit consideration (more units issued per dollar of property contributed) in return for a longer commitment, and the contributor trades liquidity for the better headline economics. The longer the lock-up, the more the contributor's incentives align with the REIT's near-term performance, which is partly why founder rolls into IPO vehicles carry the longest terms.

After the lock-up, OP unit holders typically have two redemption options: cash redemption at the then-current REIT common-share market price per unit, or share-for-share conversion into REIT common stock on a 1:1 ratio. The REIT usually retains the contractual discretion to choose between paying cash or issuing shares when an OP unit holder elects to redeem, with the choice driven by the REIT's cash position and capital structure at the moment of the redemption.

Tax Treatment at Redemption

The redemption or conversion is a taxable event. The contributor recognizes:

The conversion-versus-cash choice has meaningful tax consequences, and the analysis mirrors the broader logic of how deal structure drives the tax bill in M&A. Conversion to REIT shares lets the contributor continue to defer cash recognition (the contributor can hold the REIT shares and sell them gradually, spreading gain recognition over multiple years); cash redemption recognizes the gain immediately in the redemption year. Sophisticated contributors and their tax advisors model both scenarios in advance and structure the redemption to maximize after-tax outcomes.

The clean lifecycle (contribute, hold, redeem on the contributor's own schedule or die holding) assumes nothing disturbs the partnership in the meantime. Two partnership-tax rules can pull gain recognition forward, and both routinely surface in structuring memos.

The first is the disguised sale rule. If the contribution is paired with cash or debt-financed distributions back to the contributor inside a defined window (generally 2 years), the IRS can recharacterize the deal as a partial sale and tax the contributor in the current year, which is exactly the outcome the 721 structure was meant to avoid. The second is the Section 704(c) built-in gain allocation: when the OP later sells the contributed property, the original built-in gain is specially allocated back to the contributing partner under the "ceiling rule," so a contributor can owe tax on appreciation they thought was still deferred even though they never touched their units.

Two further mechanics round out the picture. The partnership agreement maintains a capital account for each partner tracking allocations of income, loss, and distributions, and that bookkeeping governs what each partner is ultimately entitled to receive. And state treatment is not uniform: some states conform fully to the federal 721 deferral while others diverge, so a contributor's state of residence can change the after-tax math even when the federal answer is clean.