DownREIT: How It Works, Who It Fits, and the Catch

How a DownREIT works

A REIT that wants your building, and that you want to own a piece of, can offer partnership units instead of cash. In a DownREIT, the REIT (often through a subsidiary) is the managing partner of a partnership that owns your contributed property and sometimes other REIT properties. You become a limited partner.

• Contribution. Under IRC 721(a), no gain is recognized when property is contributed to a partnership for a partnership interest.
• Income. The partnership agreement usually sets distributions on your units equal to the dividend on a REIT share, so you get REIT-like cash flow without owning REIT stock.
• Exit. After a lockout period set in the agreement, you can tender units for REIT shares or cash, at the REIT's choice. That exchange is a taxable sale of a partnership interest. You can redeem in tranches over many years to spread the gain.
• Estate. Units held until death get a basis step-up under IRC 1014, so heirs can often redeem with little or no gain.

The structure is a cousin of the 721 UPREIT. In an UPREIT, the operating partnership holds substantially all of the REIT's assets. In a DownREIT, the partnership holds a narrower set of properties, so the link between your units and the REIT's value is created by contract.

The tax traps at closing

• Disguised sale. Under IRC 707(a)(2)(B) and Treas. Reg. 1.707-3, if you contribute property and receive cash or other consideration within two years, the transfers are presumed to be a sale unless the facts clearly show otherwise. Any cash at closing needs careful structuring, and some debt-financed distributions have specific exceptions in Treas. Reg. 1.707-5.
• Debt relief. If the partnership takes over a mortgage, your share of liabilities drops. Under IRC 752 and 731, a decrease treated as a cash distribution in excess of your basis is taxable gain. Owners with debt above basis need an allocation of partnership debt to them, often through a recourse-style payment obligation. Regulations issued in 2016 and finalized in 2019 disregard so-called bottom-dollar payment obligations, so older techniques may no longer work.
• Built-in gain stays with you. Under IRC 704(c), the pre-contribution gain is allocated to you if the partnership sells your property. DownREIT deals usually include a tax protection agreement in which the REIT agrees not to sell for a period, or to compensate you if it does.
• Seven-year rules. If the partnership distributes your contributed property to another partner within 7 years (704(c)(1)(B)), or distributes other property to you within 7 years (IRC 737), gain can be triggered.

Who it fits, and who it does not

Good fit: owners of larger, institutional-quality properties in a REIT's target market; owners in their later years who want steady income, no management, and a step-up for heirs; families who want to divide one building into many small, redeemable units.

Poor fit: owners of smaller or non-core properties (REITs rarely issue units for them); anyone who wants to stay a hands-on real estate investor; anyone who may need a large lump of cash soon. Partnership units are not real property, so you cannot do a 1031 exchange out of a DownREIT later. That one-way door matters.

Worked example (engine-computed)

Assumptions (labeled, not a client case): married filing jointly, 2026, $150,000 of other ordinary income. The owners contribute an apartment building with $1,200,000 of gain ($300,000 of unrecaptured Section 1250 gain and $900,000 of other long-term gain), no cash at closing, and debt that stays allocated to them.

Computed with the Big Sale Tax engine as the increase in 2026 tax from a cash sale. The DownREIT defers that tax, but it does not erase it: redeeming units later triggers the deferred gain at the tax rates of that year, and if the REIT sells the building, the 704(c) gain comes back to the owners unless a tax protection agreement compensates them. Held until death, the units get a stepped-up basis.

IRS stance and audit risk

Section 721 contributions are routine, and DownREITs are not listed transactions or transactions of interest. The IRS scrutinizes them through the disguised sale rules, the liability allocation rules under Section 752, and the partnership anti-abuse rule in Treas. Reg. 1.701-2, especially where the units are engineered to act exactly like REIT stock while the contributor keeps cash or debt protection. Required disclosures under Treas. Reg. 1.707-8 apply when cash moves within two years and the parties do not treat it as a sale.

Costs and fees

• Legal and tax work on the contribution agreement, partnership agreement and tax protection agreement, for both sides.
• Lender consent or loan assumption fees, and possibly transfer taxes depending on the state and structure.
• Pricing: the REIT values your property and its units; the exchange ratio is a negotiated price, often at a discount to a cash offer.
• Ongoing: no management fees charged to you directly, but you take REIT share price and dividend risk, and K-1 reporting in multiple states.

How it compares with a Section 453 installment sale

Both spread tax over time. A DownREIT lets you choose when to recognize gain by redeeming units in tranches, and your income tracks a diversified REIT. An installment sale fixes the schedule in the note: you report gain as principal is paid, at an interest rate at or above the applicable federal rate, and your income depends on one buyer's credit. That is managed with a real down payment, a first-position deed of trust, acceleration and due-on-sale clauses, and default remedies; on repossession of real property Section 1038 applies (see seller financing).

The installment sale works with any qualified buyer and any property size; a DownREIT requires a REIT that wants your asset. A DownREIT gives heirs a step-up on unredeemed units; an installment note held at death is income in respect of a decedent with no step-up under IRC 691. The $5,000 Big Sale Tax Analysis models both against a cash sale and a 1031 exchange.

Frequently asked questions