731 Exchange: How UPREIT Investors May Regain 1031 Eligibility

A “731 exchange” is not technically an exchange — though that is how many investors commonly refer to it. The correct term is a Section 731 distribution, which is the provision that governs how distributions from an operating partnership (OP) to its partners are taxed. For UPREIT investors holding OP units, a real property distribution under Section 731 may reopen a path to 1031 exchange eligibility, allowing them to potentially continue deferring capital gains taxes. A 731 distribution is not a guaranteed feature of any offering and is uncommon in practice. However, where a sponsor is willing to pursue it, the mechanism can meaningfully alter the tax outlook for investors.

This question typically arises after an investor has contributed property to an UPREIT through a 721 exchange, which defers gains but forfeits 1031 eligibility on that interest. Understanding whether — and how — that eligibility can be restored is central to any long-term, tax-sensitive real estate strategy.

Key takeaways:

• “731 exchange” is the shorthand we use for a Section 731 distribution. Section 731 is not an “exchange” in the way 1031 or 721 exchanges are — it is the tax rule governing how a partnership’s distributions to its investors are taxed.
• A Section 731 distribution can take the form of cash, marketable securities, or real property. Only a real property distribution returns an investor to direct real estate that may again qualify for a 1031 exchange.
• The real property path involves the operating partnership transferring a fee simple real estate interest to the investor, whose basis in that property is governed by Section 732(b) of the IRC.
• A potential benefit of a Section 731 real property distribution is the ability to reinvest in like-kind real property, which may preserve eligibility for future 1031 exchanges and continued tax deferral. However, compliance with IRS regulations is complex — missteps can result in unexpected tax liabilities.
• A 731 distribution is a complex process that unfolds on the sponsor’s timeline. Investors generally cannot compel whether or when one occurs, and it is not a guaranteed feature of any offering.

This post breaks down how a 731 distribution works, what conditions must be met, where it fits alongside 721 and 1031 exchanges, and what risks you should understand before treating this as part of your long-term tax planning strategy. As always, consult a qualified tax advisor regarding your specific situation.

What Is a 731 Exchange (Section 731 Distribution)?

A Section 731 distribution is what happens, tax-wise, when a partnership distributes cash or property back to one of its partners. In the UPREIT context, it is the mechanism that can transfer a piece of real estate directly to an investor — effectively trading their OP units for fee simple real estate instead of cash or real estate investment trust (REIT) shares.

We use the phrase “731 exchange” because that is how investors tend to ask about it, but the label is imprecise in a way that matters. With a 1031 exchange or a 721 exchange, the tax break is built into the law — follow the rules and your tax bill gets postponed automatically. However, Section 731 is not an “exchange” in the technical sense. It is the IRC provision that determines how partnership distributions are taxed. Treating it as though it were a formal exchange mechanism can lead to imprecise planning.

The underlying 731 rule works as follows. When you invest in a partnership — including an UPREIT’s operating partnership — you carry a tax basis in that partnership interest. That basis represents, broadly speaking, your tax-paid investment in the partnership. Under Section 731, when the partnership distributes money to you:

• If the amount distributed is less than or equal to your basis, the distribution is generally not a taxable event. You receive a return of your tax investment without triggering gain.
• If the amount distributed exceeds your basis, you generally recognize capital gain on the excess.

Cash distribution example: Suppose you hold operating partnership units in an UPREIT with an adjusted basis of $500,000, and the partnership distributes cash of $400,000. Because the distribution is below your basis, it is generally not taxable, and your remaining basis is reduced to $100,000. If instead the partnership distributed $600,000 in cash, the $100,000 above your basis would generally be treated as a capital gain. The tax outcome in any specific case depends on your individual circumstances.

Distributions of property work differently. Gain is generally not recognized on a distribution of property itself, even where the property’s value exceeds your basis. Instead, the property takes a basis in your hands determined under Section 732, and the deferred gain carries forward into that property. Those rules are covered below.

How a 731 Exchange Could Potentially Restore 1031 Eligibility

If the operating partnership distributes a direct real estate interest to an OP-unit holder under Section 731, that investor once again owns fee simple real estate that may qualify for a 1031 exchange.

This is the central appeal of the 731 path. The investor re-enters the world of direct real estate ownership — and with it, the potential to perform a 1031 exchange into a like-kind replacement property, continuing to defer capital gains taxes.

How that distribution takes shape, however, depends entirely on its form.

What Can a Partnership Distribute Under Section 731?

A Section 731 distribution can come out in one of three forms — cash, marketable securities, or real property — and the form matters, because only real property can put an investor back into 1031-eligible real estate.

Here is how each path works:

• Cash: A cash distribution is generally not taxable up to your adjusted basis in the OP units — it is treated as a return of capital. Any amount above that basis generally triggers capital gains. However, cash does not give you real estate to exchange into, so a cash distribution does not restore 1031 eligibility.
• Marketable securities: Under Section 731(c), marketable securities are generally treated like cash for these purposes — the same tax treatment applies, and the same limitation holds. Receiving marketable securities does not put fee simple real estate back in your hands, so it does not reopen a 1031 exchange path.
• Real property: This is the only form that transfers a direct real estate interest back to the investor and can therefore reopen the possibility of a 1031 exchange. The mechanics of this path are explained in the next section.

The Real-Property Path: How It Can Restore 1031 Eligibility

The chain of events, at its core, works as follows: an investor holds OP units → the operating partnership distributes real property to that investor under Section 731 → the investor now holds a direct, potentially 1031-eligible real estate interest → the investor may then pursue a 1031 exchange to continue deferring capital gains taxes.

An investor who receives distributed real property and prefers passive ownership may, after satisfying the applicable holding and qualified-use requirements, pursue a 1031 exchange of that property into a Delaware Statutory Trust (DST) interest. That exchange is subject to the same 45-day identification and 180-day closing deadlines, and the same qualified intermediary requirements, as any other 1031 exchange.

An important qualification applies throughout: this path depends entirely on the sponsor’s willingness to pursue the distribution. It is conditional, not guaranteed. The fuller treatment of that risk appears in the risks section below.

The Mechanics of Potentially Regaining 1031 Eligibility via Section 731

Executing a Section 731 distribution is a multi-step process that requires cooperation between the investor (the limited partner) and the REIT (the general partner). The steps below are illustrative and general — they are not a guarantee of availability in any specific offering.

Step 1: The Strategic Redemption of OP Units

The investor initiates a request to redeem their OP units. Redemption rights are subject to the terms of the partnership agreement, including a holding period that is commonly one year from issuance of the units. While a standard partnership agreement allows the REIT to satisfy redemptions with cash or REIT shares, an investor seeking real property must negotiate for a “redemption in-kind.” This involves the partnership identifying a specific parcel of real estate within its portfolio to distribute to the partner in exchange for their units. That negotiation is precisely why the outcome is sponsor-dependent.

Step 2: Distribution of “Like-Kind” Real Estate

The partnership transfers the deed of the identified property to the investor. 

• Section 732(b) applies where the distribution liquidates the investor’s entire interest in the operating partnership: the investor’s basis in the property generally equals their adjusted basis in the OP units, reduced by any money distributed in the same transaction. 
• If the investor retains a partial interest, Section 732(a) applies instead, and the property’s basis is generally the partnership’s own basis in that property, capped at the investor’s outside basis. 

Either way, this “substituted basis” generally preserves the inherent gain rather than realizing it, so the deferred gain carries forward into the property. Which provision applies depends on how the transaction is structured and should be analyzed with a qualified tax advisor.

Step 3: Establishing Qualified Use and Holding Periods

Once the investor holds fee simple title, the property cannot be sold immediately with a claim for 1031 treatment. Under Section 1031, a replacement property must be “held for productive use in a trade or business or for investment.” The investor must establish a sufficient holding period to demonstrate that the property was not acquired solely for immediate resale. What constitutes a sufficient holding period is fact-specific and should be determined in consultation with a qualified tax advisor.

Step 4: Pursue a Like-Kind Replacement Property

With qualifying real estate in hand and the holding period satisfied, the investor may engage a qualified intermediary (QI) and initiate a 1031 exchange in compliance with IRS requirements. The exchange must comply with the 45-day identification rule and the 180-day closing rule. Proceeds from the relinquished property must flow through the QI at all times; the investor cannot receive the funds directly.

How Does a 731 Exchange Fit With 721 Exchanges and 1031 Exchanges?

The three provisions describe a potential lifecycle: a 1031 exchange defers gain on a sale → optionally, a 721 exchange contributes property into an UPREIT for OP units → potentially, a Section 731 distribution transfers real property back out, restoring 1031 eligibility.

Each step in this sequence involves distinct trade-offs. The table below summarizes how these three structures compare:

Potential Benefits of a 731 Exchange

A Section 731 real property distribution offers OP-unit holders a potential path to regain flexibility and 1031 exchange eligibility. For investors managing long-horizon, tax-sensitive real estate portfolios — particularly pre-retirees and retirees with estate planning considerations — that flexibility can be meaningful.

Potential benefits include:

• Path back to 1031 eligibility: By regaining fee simple real estate, the investor may once again pursue a 1031 exchange into a like-kind replacement property, potentially continuing to defer capital gains taxes.
• Potential exit from the operating partnership structure while maintaining tax deferral: Depending on the investor’s basis and the value of the distributed property, the distribution may occur without an immediate taxable event — preserving deferred gain rather than triggering it.
• Renewed flexibility to continue exchanging: Direct real estate ownership restores the investor’s ability to pursue future exchanges into properties that better align with evolving goals, income needs, or estate plans.

These benefits are conditional and depend on facts specific to each investor’s situation and the terms of the applicable partnership agreement. They should be evaluated with the risks described below — and with the guidance of qualified legal and tax counsel.

Risks and Limitations of a 731 Exchange

These transactions are complex, slow, sponsor-controlled, and may trigger taxable gains. Any investor weighing a 731 distribution should understand the following limitations before assuming it is available.

• Complex legal and tax structuring: A Section 731 real property distribution requires significant legal documentation, operating partnership agreement review, and involvement of qualified tax and legal professionals. The substituted basis rules under Section 732(b) introduce additional complexity that requires careful analysis.
• Long, uncertain timelines: Execution depends on property-level feasibility, the sponsor’s operational priorities, and the mechanics of identifying a suitable parcel within the portfolio. The process can take a substantial amount of time, with no guarantee of completion.
• Limited investor control: Investors in an operating partnership typically cannot force whether or when a sponsor pursues a Section 731 real property distribution. The decision rests with the general partner. An investor may generally request redemption subject to the terms and holding-period restrictions of the partnership agreement, but satisfying that request in real property form is not the REIT’s obligation under most standard agreements.
• Potential for taxable gain: The IRS rules governing Section 731 distributions include circumstances in which gain can be recognized — particularly if cash or other property is distributed alongside real estate, or if the amount distributed exceeds the investor’s adjusted basis. These scenarios require specific analysis.
• The seven-year rule under Section 737: If an investor contributed appreciated real property to the operating partnership in a 721 exchange and later receives different property from that partnership within seven years of the contribution, they may be required to recognize gain — generally limited to their net precontribution gain. This can significantly change the tax outcome of a Section 731 distribution and requires analysis specific to the investor’s contribution date and basis.
• Other technical triggers: Two additional rules warrant professional review. First, debt relief treated as a cash distribution — a reduction in the investor’s share of partnership liabilities under Section 752(b) — can trigger gain under Section 731(a) even when no cash changes hands. Second, the “hot asset” rules under Section 751 can apply when a disproportionate distribution involves depreciation recapture, converting part of the gain from capital to ordinary income. Both rules are fact-specific and require analysis by a qualified tax advisor.

Why Are 731 Exchanges Uncommon? The Sponsor’s Perspective

731 distributions are rare largely because they are often economically unattractive for sponsors. For the REIT managing an UPREIT’s operating partnership, accommodating a redemption in-kind involves several operational and economic costs:

• Expensive and operationally complex: Carving a specific property out of a portfolio to transfer in-kind requires legal work, title transfers, appraisals, and potentially complex restructuring at the operating-partnership level. The process is meaningfully more involved than a cash redemption.
• May require liquidity or restructuring: Distributing a property reduces the portfolio’s asset base and may require the REIT to restructure debt or refinance existing obligations, depending on how the property is collateralized.
• Misalignment of economic interests: If the investor completes a successful 1031 exchange after receiving the property — particularly into a different sponsor’s offering — the original REIT loses that investor’s assets under management (AUM) and the associated fee streams. For the sponsor, that outcome provides no economic benefit and creates meaningful transaction costs.

None of this makes a 731 distribution improper — it simply explains why sponsors rarely pursue one voluntarily. For investors, the practical takeaway is to treat a potential 731 exit as a possibility to discuss and confirm, not a standard feature to expect.

Frequently Asked Questions

Is a 731 exchange the same as a Section 731 distribution?

Yes. “731 exchange” is the shorthand we use for a Section 731 distribution, because that is how investors tend to ask about it. The terminology is convenient but imprecise, and it can be misleading. Section 731 is not technically an exchange like Section 1031 or 721 — it is the tax provision that governs how a partnership’s distributions to its investors are taxed.

Is a 731 exchange a “reversal” of the 1031-to-UPREIT process?

Not exactly, though the parallel is understandable. A 721 exchange allows an investor to contribute fee simple real estate into an UPREIT in exchange for OP units. A Section 731 distribution can return real property from the operating partnership to the investor. But the two transactions carry different tax consequences, different structural requirements, and different levels of investor control. The 731 path does not undo the 721 exchange; it creates a new ownership structure, with a substituted basis that preserves the deferred gain.

Can you do a 1031 exchange after a 721 exchange?

Not directly on the OP units themselves, because units in an operating partnership are not real property and are not 1031-eligible. A 1031 exchange generally becomes possible only after the investor once again holds direct real estate — for example, through a Section 731 distribution of real property — and satisfies the holding and qualified-use requirements.

How do you exit an UPREIT?

Exit routes depend entirely on the partnership agreement and the sponsor’s programs. The most common are converting OP units into REIT shares and selling those shares, or redeeming units for cash under the REIT’s redemption program, which is typically subject to holding periods, caps, and suspension rights. Both are generally taxable events. A Section 731 distribution of real property is a third, far less common route, and it is available only where the sponsor is willing to pursue it. Some investors hold OP units until death, at which point heirs may receive a step-up in basis. Each route carries different tax consequences and should be reviewed with a qualified tax advisor.

How is a 731 distribution taxed?

A distribution is generally not taxable up to the investor’s basis in their OP units, treated as a return of capital. Amounts above basis, or distributions of cash or marketable securities in excess of basis, can generate capital gains. When real property is distributed, it carries a substituted basis under Section 732(b), preserving the investor’s deferred gain. Because the tax outcome depends heavily on individual circumstances, consult a qualified tax advisor before proceeding.

How long does a 731 exchange take?

There is no standard timeline, and that uncertainty is part of what makes this path operationally challenging. Because the process depends on negotiating a redemption in-kind and on property-level feasibility within the partnership, timelines vary significantly, and completion is not guaranteed.

Final Notes on Section 731 Distributions

Understanding a Section 731 real property distribution matters because it clarifies why 1031 eligibility is not necessarily lost once an investor holds OP units. That said, this is not a feature investors should expect to access readily. Most operating partnership agreements permit the general partner to satisfy a redemption only in cash or REIT shares. Sponsors willing to negotiate a distribution in kind are uncommon, for the practical reasons outlined above. Treat this as background for a conversation with your advisors and the sponsor — not as a planned exit route.

The rules discussed here are complex and highly fact-specific. Basis, holding periods, allocated debt, and the terms of the partnership agreement can each change the outcome, and several provisions can override the general rule. This article is not tax or legal advice. Review your specific situation with a qualified tax advisor and attorney before taking action, and confirm availability directly with the sponsor.

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