A CPA’s Guide to 721 Exchanges: Basis, Debt, and Reporting

By Jerry Baker

A CPA’s review of a 721 exchange should track the client’s tax basis, debt, and cash as property moves into an operating partnership, or OP. This guide covers the records, closing questions, and yearly tax work needed to review the deal. Deferring tax does not mean making that tax disappear.

Start with what the client is actually doing

“I’m doing a 721” is a starting point, not a complete set of facts. Is the client contributing a building directly? Is a DST changing ownership through a planned contribution? Is the client receiving units, cash, or both? Who owns the property for federal tax purposes, and who will own the units?

Section 721 generally provides nonrecognition, or no current gain or loss, when property is put into an OP in return for an interest in it. That rule has exceptions, including the investment-company rule. It also does not turn payment for services into a tax-free property contribution. Name each step before you work out its tax result. [1]

My role is to help a client understand the investment and obtain useful information. The client’s CPA and tax counsel decide how the rules apply to that client. I want those conversations to begin while the terms can still be changed, rather than after everyone has signed.

Start with a one-page map of the deal. Show each entity, what it transfers, what it receives, and the order of the steps. Add expected dates and unresolved conditions. A map often reveals a cash payment, an ownership change, or a debt payoff that was missing from the first conversation.

Build a tax file that survives the closing

Ask for more than the latest tax return. A low-basis property may carry a history of exchanges, improvements, refinancings, and ownership changes. The purchase price from years ago is rarely the final answer.

• Collect original closing statements and records from prior exchanges.
• Reconcile land, building, improvement, and other asset basis schedules.
• Obtain depreciation records, including separate components and prior adjustments.
• List current debt, prior refinancings, guarantees, and how loan proceeds were used.
• Identify suspended losses and the reason each amount was suspended.
• Confirm tax owner, entity classification, and each owner’s share.
• Keep the final contribution, partnership, and tax-protection agreements together.

This is my suggested file structure, not a claim that every item applies to every client. Mark missing records and assign a person to obtain them. A blank cell should remain visibly unresolved; it should not quietly become zero in the model.

Keep market value and tax basis in separate columns. Market value helps set the deal between the owner and the OP. Tax basis helps determine gain, losses, and future adjustments. A large gap between those figures is often the reason the client is considering the contribution.

Keep four different numbers separate

Keep four figures distinct. One is the property’s value. Another is the client’s tax basis in the OP units, called outside basis. A third is the OP’s basis in its property, called inside basis. The fourth is the capital account in the OP’s records. Similar labels can hide very different amounts.

Section 722 supplies the starting basis rule for a contributed partnership interest. Section 723 supplies the starting basis rule for the property received by the partnership. Both generally carry over adjusted basis, with the specific statutory adjustment for gain recognized under Section 721(b). Then apply the debt rules and any other rules that fit the facts. [2] [3]

The IRS expressly warns that the capital account on Schedule K-1 does not establish the partner’s adjusted outside basis. Among other differences, outside basis reflects the partner’s share of partnership liabilities. Keep a separate basis file. Do not use the year-end capital figure in its place. [4]

For a simple example, assume land worth $1 million has $250,000 of adjusted basis. Ignore debt, fees, and special rules. A qualifying contribution does not ordinarily give the owner $1 million of tax basis just because the owner receives units worth that amount. The value gap remains important after closing.

Prepare a debt bridge before promising deferral

Section 752 generally treats an increase in a partner’s share of liabilities as a money contribution and a decrease as a money distribution. That makes debt changes part of the tax calculation even when no cash reaches the client’s bank account. [5]

Determine the old liabilities and the client’s properly calculated share of partnership liabilities after closing. Do not simply multiply total partnership debt by the client’s ownership percentage. The applicable recourse and nonrecourse allocation rules require a separate analysis. Publication 541 explains the distinction and related basis effects. [6]

Consider this narrow illustration. Assume contributed-property basis is $300,000, old debt is $400,000, and the properly determined new liability share is $250,000. Ignoring all other adjustments, net debt relief is $150,000. The remaining outside basis is $150,000.

Change the new liability share to $50,000. Net relief becomes $350,000. Under the basic distribution rule, the amount above the $300,000 basis produces $50,000 of gain, leaving zero basis. This isolates the Section 752 and Section 731 calculation; it does not establish that the deal avoids disguised-sale treatment or any other issue. [7]

Ask the partnership’s tax team to support its liability allocation and explain when it may change. Have counsel review any proposed guarantee. What must the client pay, and how do the tax rules treat that promise? A document added merely to make the spreadsheet look better is not a substitute for that analysis.

Review cash and debt under the disguised-sale rules

A property transfer and a related cash payment may count as a full or partial sale. The analysis looks at the arrangement’s facts, including whether payment depends on the risks of partnership operations. Calling a payment a distribution does not settle the issue. [8]

The rules make certain assumptions for transfers within or beyond two years. Facts can rebut, or overturn, those assumptions. Those rules do not say that every DST can safely move into an OP after two years. They address a particular partnership-tax question, and facts can overcome the presumptions.

Liabilities have their own disguised-sale rules. A qualified liability can receive different treatment from another liability, but the definition has conditions. Recent borrowing, the use of proceeds, and the relationship between the debt and the transfer all deserve attention. A debt number is not enough without its history. [9]

I would put every expected payment on a closing schedule: cash to the owner, loan payoffs, expense reimbursements, fees, reserves, and later promised distributions. For each item, the tax team should record the proposed treatment and supporting facts. That reduces the risk of modeling a pure contribution while signing a part-sale arrangement.

Track built-in gain and the allocation method

Section 704(c) generally requires tax allocations that account for the gap between contributed-property value and tax basis. The aim is to keep the pre-contribution tax gain or loss from being shifted inappropriately to other partners. That gap can affect allocations while the property is held and when it is sold. [10]

Ask which tax allocation method applies. The traditional, curative, and remedial approaches can produce different timing and allocation results. The partnership agreement and its tax schedules matter; a broad statement that “gain carries over” does not explain the client’s annual experience. [11]

For the $1 million land example with $250,000 basis, the initial built-in gain is $750,000. If the partnership later sells that land for $1 million, with no intervening adjustments, that pre-contribution gain is generally allocated to the contributor. Future gain above the contribution value requires its own allocation analysis.

Ask for the opening schedule for each asset. Agree on how to get changes each year. The Form 1065 instructions address reporting of net unrecognized Section 704(c) amounts and related allocations. A net figure is useful, but the CPA may need supporting detail to understand what changed and why. [12]

Make annual reporting a recurring process

Receiving a K-1 does not mean Schedule E disappears. Partnership rental and business items may still flow to Schedule E, while other items go elsewhere on the return. The K-1 supplies information; the partner’s return applies the relevant rules. [4]

Track outside basis from the start to the end of each year. Section 705 generally increases basis for allocated income and decreases it for distributions, losses, and certain other items. Liability changes must also be tracked. Cash received and taxable income are separate figures, so tax can arise without a matching cash payment. [13]

For a separate, simplified annual example, start with $150,000 basis. Add $20,000 of allocated taxable income and subtract $30,000 of cash distributions. With no debt change or other adjustment, ending basis is $140,000. The $30,000 bank deposit is neither the income figure nor the remaining basis.

My suggested year-end packet includes the K-1, all attached statements, distribution history, liability changes, asset-sale notices, and the prior basis workpaper. Add state information and any ownership changes. Put the preparer’s unresolved questions in a short list instead of burying them in email threads.

Agree on a plan for tax estimates and any filing extension before the first tax season. A late K-1 can delay the return. Plan for that risk. The CPA should use the best facts to estimate tax. Update that work when final figures arrive.

Keep loss limitations in separate workpapers

A loss on the OP’s books may not give the client a deduction. Basis, at-risk, passive-activity, and other limits can apply. The K-1 instructions describe the order of the principal partner-level limits. [4]

At-risk amounts and tax basis are different. Certain qualified nonrecourse real-estate financing can count for at-risk purposes, while other nonrecourse amounts may not. Passive losses also have their own rules. Do not assume that contributing the old property automatically releases every suspended loss. [14]

I would label each suspended balance by its source and limitation. A single line called “tax losses” leaves too much room for error. Ask how each balance is treated when the client joins, while units are held, and when they are sold. This helps the client understand why an attractive paper loss may offer no current tax benefit.

Model the legal form of the exit

Read the redemption provision before estimating tax from a future exit. The partnership may redeem units, the REIT may acquire them, or another structure may apply. Cash, shares, liability relief, basis, and prior allocations all matter. The contract may limit the client’s right to make a request.

Section 741 generally gives capital treatment to gain or loss on a sale of a partnership interest, subject to Section 751. Section 751 can make a portion ordinary, including amounts tied to certain recapture items. “It is all capital gain” is not a reliable shortcut. [15] [16]

Partnership distributions follow different rules. Section 731 also treats certain marketable securities as money, with specified exceptions and adjustments. Receiving shares does not, by itself, prove that no gain arises. [7]

Ask for a tax estimate for the actual deal before a large redemption. Update the last basis figure for this year’s income, payments, and debt. If the client wants to sell in stages, confirm both the contract’s flexibility and the tax consequences of each stage. Do not promise a tax bracket result years before the relevant figures exist.

Read tax protection as a contract

A tax-protection agreement may help. Its name does not tell you what it covers. Identify protected taxpayers, assets, debt levels, events, duration, exclusions, remedies, and early termination terms. Have counsel explain whether the protection prevents an action or instead requires a payment after it occurs.

One historical example comes from a February 2025 Generation Income Properties filing. It described protection tied to property sales and debt. The term was ten years, but it could end sooner. The filing also described adjustments to the payment calculation. Those were that deal’s terms. They do not govern all UPREITs. [17]

The CPA should model the tax while counsel reviews the promise. Ask how a protection payment itself is treated, who must pay it, and what happens if that party cannot perform. I would keep a dated contract summary with the basis schedules so that a later adviser can see the limits.

Plan for death, gifts, and family transfers separately

Inherited partnership interests require more than the phrase “step-up.” The heir’s outside basis and any adjustment to the partnership’s underlying assets are separate questions. Section 743 addresses inside-basis adjustments after certain transfers, including where a Section 754 election applies or a mandatory loss rule is triggered. [18]

Publication 541 discusses the inherited interest’s basis, including relevant partnership liabilities and income in respect of a decedent. The calculation can involve a decrease as well as an increase in value. Death does not guarantee a cash payment or unrestricted transfer rights. [6]

Coordinate with estate counsel and the partnership. Ask what notices, valuations, elections, and ownership documents will be needed. Keep the opening contribution records available for the successor’s adviser. A plan that works only because the original CPA remembers an old conversation is not a durable plan.

Give the client a usable closing summary

Before closing, I would ask the tax team for a short summary. What gain is due now? What are the starting outside basis and built-in gain? Which debt figures are still estimates? Separate confirmed figures from estimates. Show how the result changes if debt or cash at closing differs from the proposal.

After closing, replace estimates with final numbers and retain the supporting settlement records. Confirm who will provide each tax schedule and whom the CPA should contact. A short client note should explain the change in ownership, likely reporting needs, liquidity limits, and events that could create taxable income.

For a DST that began with a 1031 exchange, preserve the earlier exchange file too. A later contribution does not repair a failed initial exchange. Ordinary OP units generally do not count as real property for Section 1031. A direct contribution under Section 721 may still qualify under its own rules. [19]

The goal is a record another qualified adviser can follow. Review the deal before it closes. Keep a clear record of the final facts. Then check it each year. A planned tax deferral should not become a tax position no one can explain.

Connect the tax work to the client’s cash plan

A correct tax model can still leave out a basic concern: the client needs money to live on. I would ask the CPA and client to compare cash needs with the deal’s terms. Keep taxes, living costs, and large planned expenses on the same page. Show which needs must be met from other funds.

For example, suppose a client has $80,000 in a bank account set aside for taxes and emergencies. The client expects a $30,000 tax payment and wants to keep $40,000 for urgent needs. That leaves $10,000 for other uses. An OP account statement may show much more value, but value is not cash the client can spend today.

Those figures are made up. They do not estimate anyone’s tax. Their purpose is to make the cash gap visible. If the plan needs a unit sale to cover a bill, ask whether the client has the right to sell, when payment could arrive, and what the sale would cost after tax.

I would also ask who should receive notices from the OP. A client may get a long email about a planned asset sale and think it is routine news. The CPA may need that notice to update a tax estimate. With the client’s consent, agree on a way to share those notices promptly.

State questions belong in that plan too. Give the CPA the client’s home state, any move during the year, and the OP’s state tax schedules. Ask which returns may be needed, what credits may apply, and how state rules treat the deal. Do not assume that a federal result settles each state’s treatment.

Finally, agree on who owns each task. The client gathers missing records. The OP’s tax team explains its schedules. Counsel reviews the terms and legal issues. The CPA decides how to prepare the client’s return. My team helps obtain investment information. A named person and due date for each open item can save weeks of avoidable follow-up.

Frequently asked questions

Does a 721 exchange require a special election on Form 8824?

Form 8824 is associated with like-kind exchanges. A standalone partnership contribution needs its own reporting analysis; it is not made qualifying merely by filing that form. If an earlier 1031 exchange occurred, preserve and report that separate step correctly. The CPA should determine all required forms and disclosures from the actual transaction.

Can I use the K-1 capital account as the client’s basis?

No. The IRS warns that the reported capital account may differ from outside basis. Maintain a separate basis schedule, including liabilities and client-level adjustments. Reconcile differences rather than assuming the partnership’s figure is wrong. [4]

Does a K-1 replace Schedule E?

No. It provides information that may be reported on Schedule E and other parts of the return. The item’s character and the client’s facts control where it goes. A K-1 is not a separate tax system that replaces the client’s normal return. [4]

Can liability relief create gain without cash?

Yes. A net liability decrease can count as a money distribution. Gain may arise when that deemed money exceeds the relevant outside basis. Analyze liability allocation and disguised-sale rules separately before concluding that a proposed contribution is fully deferred. [5] [7]

Does waiting two years solve all tax concerns?

No. The disguised-sale regulations contain timing presumptions that depend on facts. They do not create a blanket DST holding-period safe harbor or settle the validity of an earlier exchange. The whole arrangement needs review. [8]

Can the client receive a tax bill without a distribution?

Yes. Allocated income and cash payments need not match. Asset sales, special allocations, and debt changes can affect the client. The CPA should review partnership notices and update tax estimates instead of relying only on the distribution rate. [6]

Will heirs automatically avoid all deferred gain?

No. Outside basis, inside-basis adjustments, income in respect of a decedent, and the governing documents must be considered. Ask the partnership and estate advisers how the specific interest will be treated. A general reference to inherited basis is not a complete estate analysis. [18]

Educational information, not an offer or a personal tax, legal, or investment recommendation. Examples are hypothetical and omit stated adjustments. Tax treatment depends on your facts and current law. Review your transaction with your CPA, attorney, and qualified intermediary. Real estate investments can lose value and may be illiquid.