IRC Section 721: Guide to Nonrecognition of Gain or Loss on Contribution to a Partnership

IRC Section 721 is a provision in the U.S. Internal Revenue Code that governs the tax treatment of property contributed to a partnership in exchange for an interest in that partnership. The central rule is straightforward: no gain or loss is recognized by either the partnership or the contributing partner when property is contributed in exchange for a partnership interest. This allows for tax-efficient formation and restructuring of partnerships, including limited liability companies (LLCs) taxed as partnerships.

Section 721 is most commonly used in the context of real estate and private equity, but it applies broadly to any property (cash, real estate, intellectual property, etc.) contributed to a partnership. The provision is designed to facilitate the pooling of assets and capital without triggering immediate tax consequences, thereby promoting business growth and investment.

When Is IRC Section 721 Used?

Section 721 is used in several scenarios:

• Formation of Partnerships: When two or more parties contribute property to start a partnership or LLC taxed as a partnership.

• Business Acquisitions: Private equity deals often use Section 721 to allow sellers to contribute assets in exchange for partnership interests, deferring taxes on the transaction.

• Real Estate Investment Trusts (REITs): Investors can use a "721 exchange" to transfer property into an umbrella partnership real estate investment trust (UPREIT), receiving operating partnership units instead of cash, and deferring capital gains taxes.

• Restructuring or Funding: Existing partnerships can accept new property contributions from current or new partners without triggering taxable events.

How Does a 721 Exchange Work?

A 721 exchange is a specific application of Section 721, most often seen in real estate. Here’s a simplified example:

1. Investor Sells Property: An investor sells a property and may use a 1031 exchange to defer capital gains by purchasing a like-kind property.

2. Contribution to UPREIT: Instead of holding the new property indefinitely, the investor contributes it to an UPREIT in exchange for operating partnership units.

3. Tax Deferral: The investor receives partnership units instead of cash, and under Section 721, no gain or loss is recognized at the time of contribution.

This process allows investors to diversify and increase liquidity while still deferring capital gains and depreciation recapture taxes.

Key Rules and Exceptions Under IRC Section 721

General Rule

• No gain or loss is recognized on the contribution of property to a partnership in exchange for a partnership interest.

Exceptions to Nonrecognition

Section 721 has several important exceptions:

• Services Are Not Property: If a partner receives a partnership interest in exchange for services (rather than property), Section 721 does not apply. The value of the interest received for services is taxable as ordinary income.

• Investment Company Exception: If the partnership would be treated as an investment company (as defined in Section 351) if it were incorporated, the nonrecognition rule does not apply.

• Disguised Sales: If the contribution is part of a disguised sale, where the partner effectively sells property to the partnership, the nonrecognition rule is not available.

• Contributions Exceeding Basis: If a partner’s share of liabilities is reduced and the deemed distribution exceeds their basis in the partnership, gain may be recognized.

• Gifts: Contributions that are essentially gifts may not qualify for nonrecognition.

Statutory and Regulatory Framework

• 26 U.S.C. § 721: The statutory text provides the core rule and outlines exceptions.

• 26 CFR § 1.721(c)-1: Treasury regulations elaborate on definitions, including what constitutes a "section 721(c) partnership" and the treatment of contributions involving foreign partners.

• Revenue Rulings and IRS Guidance: The IRS has issued additional rulings clarifying the application of Section 721 in complex scenarios.

Several key cases have shaped the interpretation of Section 721, especially regarding what qualifies as "property" and the treatment of partnership interests received for services.

Diamond v. Commissioner, 492 F.2d 286 (7th Cir. 1974)

Diamond arranged financing for a land purchase and received a profits interest in the partnership that would own the land. Shortly after, he sold his interest for $40,000 and reported the gain as short-term capital gain, offset by losses.

The court held that Section 721 does not apply when a partnership interest is received in exchange for services. The profits interest Diamond received was compensation for services, not a contribution of property. The court emphasized that Section 721 is limited to property contributions and does not cover interests received for services, which are taxable as ordinary income.

“Section 721 applies only to those partners who contribute property to the partnership. The application of the regulation could also be so limited.”

The Seventh Circuit also noted that the value of a profits interest received for services may be speculative and difficult to determine at the time of receipt, but in Diamond’s case, the value was clearly established by the subsequent sale. Profits interests received for services are taxable as ordinary income and do not qualify for nonrecognition under Section 721. The court affirmed the tax court’s decision.

Norma T. Campbell v. Commissioner, 943 F.2d 815 (8th Cir. 1991)

Campbell received partnership interests after rendering services. The IRS argued this should be taxable income, not a nonrecognition event under Section 721.

The court reaffirmed that Section 721 is inapplicable where a partner receives a partnership interest in exchange for services rendered. The rationale is that only property contributions qualify for nonrecognition. The partnership’s records showed the interests were received after services were performed, supporting the IRS’s position.

“Section 721 relates to contributions of property to partnerships, but not to contributions of services, which are not property within the meaning of that section.”

The receipt of a partnership profits interest for services is taxable as ordinary income and not protected by Section 721.

Stafford v. United States, 435 F. Supp. 1036 (M.D. Ga. 1977)

Stafford assigned a lease and loan agreement to a partnership in exchange for an interest. The IRS claimed this was taxable income for services rendered.

The court found that the lease and loan agreement constituted "property" under Section 721, and the contribution was not for services. Therefore, the nonrecognition rule applied, and no gain or loss was recognized.

“The lease and loan agreement at rates substantially below existing market levels which Stafford assigned to the partnership in exchange for a partnership interest constituted property within the meaning of Section 721 of the Internal Revenue Code in connection with which no gain or loss was recognizable.”

Summary judgment for the taxpayer; the contribution qualified for nonrecognition under Section 721.

Practical Applications and Planning Considerations

Real Estate and UPREIT Transactions

Section 721 is especially valuable in real estate, where investors wish to defer capital gains taxes when transitioning from direct property ownership to more diversified investments like REITs. By contributing property to an UPREIT and receiving operating partnership units, investors can achieve liquidity and diversification without immediate tax liability.

Private Equity and Business Acquisitions

Private equity firms often use Section 721 to facilitate tax-efficient acquisitions. Sellers can contribute business assets to a partnership structure and receive partnership interests, deferring recognition of gain until they ultimately dispose of those interests.

Formation and Restructuring of Partnerships

Section 721 is also central in the formation of partnerships and LLCs, allowing founders to pool assets without triggering taxable events. This promotes entrepreneurship and business growth by removing tax barriers to collaboration.

Common Pitfalls and IRS Scrutiny

• Disguised Sales: The IRS closely scrutinizes transactions that may be disguised sales rather than true property contributions. If a partner receives cash or other consideration shortly after contributing property, the transaction may be recharacterized as a sale and taxed accordingly.

• Services vs. Property: As established in Diamond and Campbell, contributions of services do not qualify for Section 721 protection. Partners must be careful to distinguish between property and services in their transactions.

• Investment Company Exception: If the partnership would be treated as an investment company if incorporated, the nonrecognition rule does not apply. This is particularly relevant for partnerships holding primarily investment assets.

IRS Guidance and Regulations

The IRS has issued regulations and rulings further clarifying the application of Section 721:

• Regulations on Foreign Partners: Special rules apply when property is contributed to partnerships with significant foreign ownership. The IRS may require gain recognition in certain cross-border transactions to prevent tax avoidance.

• Revenue Ruling 99-5: This ruling provides guidance on the treatment of contributions to LLCs and the application of Section 721 in various scenarios.

Comparison: Section 721 vs. Section 351

Feature	Section 721 (Partnerships)	Section 351 (Corporations)
Entity Type	Partnerships, LLCs taxed as partnerships	Corporations
Property Contribution	Tax-deferred for property contributed	Tax-deferred for property contributed
Services	Not eligible for nonrecognition	Not eligible for nonrecognition
Control Requirement	No control requirement	Transferors must control 80% post-transfer
Investment Company	Exception applies (gain may be recognized)	Exception applies (gain may be recognized)

IRC Section 721 is a powerful tool for deferring taxes on property contributions to partnerships, facilitating business formation, real estate investment, and private equity transactions. However, its application is limited to property (not services), and several exceptions and IRS anti-abuse rules must be navigated carefully. Notable court decisions like Diamond v. Commissioner and Campbell v. Commissioner have reinforced the distinction between property and services, shaping the boundaries of Section 721’s protection.

For investors, business owners, and tax professionals, understanding Section 721 is essential for effective tax planning and compliance. Always consult with a qualified tax advisor to ensure that transactions are structured to maximize benefits and minimize risks under the current tax law.

For more information, review:

• 26 U.S.C. § 721

• 26 CFR § 1.721(c)-1

• Diamond v. Commissioner, 492 F.2d 286 (7th Cir. 1974)

• Campbell v. Commissioner, 943 F.2d 815 (8th Cir. 1991)

• Stafford v. United States, 435 F. Supp. 1036 (M.D. Ga. 1977)

• Revenue Ruling 99-5

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