Among the various tax-deferral strategies available to investors today, Section 721 of the Revenue Code remains a powerful tool. This provision allows asset owners to defer capital gains taxes by contributing appreciated real estate to a partnership or real estate investment trust (REIT). In exchange, the investor gains partnership interests. The introduction of foreign investors into these structures led to new compliance concerns, prompting the addition of Section 721(c) to address gain deferral in cross-border transactions. What does this new provision entail? Who is affected? Realized 1031 has shared a straightforward guide to answer these questions.
What Is a Section 721 Partnership? The Basics
Before we start discussing the new subsection, let us first understand how a regular Section 721 partnership or exchange works and gain helpful context. In this case, under Section 721(a) of the Internal Revenue Code, no gain or loss is recognized when property is contributed to a partnership in exchange for an interest in the partnership. This is a key provision in real estate structuring. Thanks to the tax deferral benefit, this strategy is often used when transferring appreciated property.
For U.S. taxpayers, this type of transfer generally proceeds without triggering immediate tax consequences, assuming requirements are met. Things became a little more complicated for foreign investors, especially when their tax liability to the U.S. is more limited.
Establishment of 721(c): Protection Against Loopholes
In 2015, the IRS raised concerns about tax deferral strategies involving the contribution of appreciated U.S. real estate to domestic partnerships with foreign partners. These structures allowed for the deferral of gain recognition, which in some cases appeared to circumvent the intended application of the Foreign Investment in Real Property Tax Act (FIRPTA).
Section 721(c) was created to close this loophole, enacted as part of the Protecting Americans from Tax Hikes (PATH) Act of 2015. This subsection compelled U.S. transferors to recognize gains at the time of contribution to any assets transferred to a partnership with partners who are foreigners, unless the partnership complies with specific reporting, allocation, and deferral procedures defined under IRS regulations.
Key Provisions of Section 721(c) Partnerships
Since the subsection requires you to realize gains, it essentially denies tax deferral for certain contributions of appreciated property. What are the requirements that will allow you to defer taxes, then? The partnership must adopt what’s called a Gain Deferral Method (GDM) and comply with reporting requirements.
- The partnership must be a U.S. partnership for tax purposes..
- The partnership must track and allocate built-in gain, recognizing it proportionally as certain gain-triggering events occur (e.g., sale, redemption, or distribution).
- The contributing partner and the partnership must file gain deferral agreements with the IRS.
- Annual compliance reporting must be maintained for each year in which the GDM applies.
This provision primarily affects U.S. persons contributing appreciated U.S. property to partnerships that include foreign partners. It was designed to prevent inappropriate deferral of U.S. taxable gains in cross-border structures. As such, failing to comply with the requirements above will result in the loss of your tax-deferred status.
Wrapping Up: What Section 721(c) Entails for U.S. and Foreign Investors
As the IRS increases its oversight of cross-border real estate transactions, provisions like Section 721(c) have become more significant for both U.S. taxpayers and partnerships involving foreign investors. If you’re entering a partnership that has foreign investors, make sure that the entity follows the requirements set by this subsection. Failure to comply may result in the loss of your tax-deferred status and immediate tax liability. If you’re a foreign investor or work with international clients in real estate, consult with a tax professional who understands Section 721(c) compliance. Proper planning can help maintain tax efficiency and avoid unexpected consequences in cross-border real estate structuring.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Article written by: Story Amplify. Story Amplify is a marketing agency that offers services such as copywriting across industries, including financial services, real estate investment services, and miscellaneous small businesses.
Sources:
https://www.investopedia.com/terms/p/path-act.asp
https://www.irs.gov/individuals/international-taxpayers/firpta-withholding
