Updated July 29, 2026. Quick answer: Because a fund holding only marketable securities would be an investment company, and IRC §721(b) switches off nonrecognition for those. Treas. Reg. §1.351-1(c)(1) sets the line at more than 80 percent of asset value in readily marketable stocks or securities. The illiquid sleeve exists to stay under it. The commonly quoted 20 percent figure is not in the Code or the regulations — it is the complement of the 80 percent ceiling plus a cushion.
The chain, one link at a time
Where the exchange-fund threshold actually comes from. IRC §721(b) switches off partnership nonrecognition for a partnership that would be an “investment company” if incorporated, and imports the §351 meaning. The percentage is not in the statute at all — it is in Treas. Reg. §1.351-1(c)(1), which requires both that the transfer diversify the transferors’ interests and that the transferee be a regulated investment company, a real estate investment trust, or a corporation “more than 80 percent of the value of whose assets (excluding cash and nonconvertible debt obligations from consideration) are held for investment and are readily marketable stocks or securities, or interests in regulated investment companies or real estate investment trusts.” “Readily marketable” is itself defined, at §1.351-1(c)(3), as part of a class traded on a securities exchange or traded or quoted regularly over the counter.
| Step | Authority | What it does |
|---|---|---|
| Contribution is tax-deferred | IRC §721(a) | No gain or loss on contributing property for a partnership interest |
| Unless the partnership is an investment company | IRC §721(b) | Turns §721(a) off, importing the §351 meaning |
| Two prongs must both be met | Treas. Reg. §1.351-1(c)(1) | Diversification and investment-company status |
| The percentage lives here | Treas. Reg. §1.351-1(c)(1)(ii)(c) | More than 80 percent of value in readily marketable stocks or securities, or interests in regulated investment companies or real estate investment trusts |
| “Readily marketable” is defined | Treas. Reg. §1.351-1(c)(3) | Part of a class traded on an exchange, or traded or quoted regularly over the counter |
Direct real estate is not a class of stock or securities traded on an exchange or quoted regularly over the counter, so it is not readily marketable and does not count toward the 80 percent. That is the reason a fund whose purpose is equity diversification owns buildings.
Note which asset does the work, because the intuitive answer is backwards. The regulation excludes cash and nonconvertible debt obligations “from consideration” — that is, from the whole computation, not just from the numerator. So a nonconvertible debt sleeve does not dilute the ratio; it drops out of both sides and leaves the remaining pool more concentrated in marketable securities. Direct real property is what actually moves the fraction. And whether any particular real-estate debt instrument is readily marketable is a class-by-class question under §1.351-1(c)(3) — regularly quoted mortgage paper is not automatically outside the counted class.
Do not treat 20 percent as a legal requirement. The number does not appear in §351(e), in §721, or anywhere in Treas. Reg. §1.351-1. What the regulation states is a ceiling on the other side of the ledger. A fund could in principle satisfy it with a different mix, and a fund that reports a specific illiquid allocation is telling you about its own policy, not reciting a rule.
Two more things the regulation does that marketing skips
The test is timed, and it looks forward if there is a plan. Treas. Reg. §1.351-1(c)(2) measures investment-company status immediately after the transfer — but where circumstances change afterwards pursuant to a plan in existence at the time of the transfer, the later circumstances govern. A fund cannot hold illiquid assets on the contribution date and shed them on a pre-arranged schedule.
An unreconciled tension worth knowing about. Congress amended IRC §351(e)(1) in 1997 to treat money, derivatives, foreign currency, REIT, RIC and publicly traded partnership interests and precious metals as “stock and securities.” The regulation already reaches RIC and REIT interests on its own text, so that is not the gap. Cash is. The statute now counts money; the operative text of Treas. Reg. §1.351-1(c) dates from the 1967-era rules and still excludes cash from the computation, and no regulation reconciling the two could be located. Nobody should describe the 80 percent test as settled law as applied to a modern fund’s asset mix.
The other half of the exchange-fund story is the exit: what §737 actually does at year seven.
Sources
IRC §721(a) and §721(b); IRC §351(e)(1); Treas. Reg. §1.351-1(c)(1), (c)(2) and (c)(3); IRC §737(a) and §737(b)(1); IRC §704(c)(1)(B). All read July 2026.
This states what the cited authority says. It is not tax or legal advice. Constructive-sale analysis, partnership nonrecognition and insider-trading defences all turn on transaction documents and facts that no page can see, and the instruments described here are executed under contracts whose terms vary by provider.