How Can I Cover a Large Amount of Debt in my 1031 Exchange?

As a real estate investor, you most likely prefer to retain any profit gained from the appreciation in your real estate assets rather than paying it in capital gains taxes when you sell a property and reinvest in another. One strategy for deferring the obligation to pay tax on a capital gain is executing a 1031 exchange.

What Is a 1031 Exchange?

The term refers to Title 26, Section 1031 of the Internal Revenue Code, and while it has changed over the years, the IRS first allowed land exchanges between farmers in 1921. The provision permits investors to sell one investment property and reinvest the proceeds in another “like-kind” asset while deferring the payment of capital gains taxes on the appreciation applicable to the relinquished property. The exchange also allows deferral of depreciation recapture and Net Income Investment Taxes, plus state capital gains taxes. Note that using a 1031 exchange can help you work toward other investment goals as well, like broadening your geographic footprint, changing sectors, or altering the composition of your portfolio in different ways.

What Does Debt Have To Do With the Exchange Process?

While the successful completion of a 1031 exchange can be a great tool to help investors defer their tax obligation on the sale of appreciated property, there are some pitfalls to watch out for. Failing to follow the IRS' rules governing the process precisely will derail the exchange and the deferral, potentially resulting in an unexpected and unwanted tax bill. Among the key considerations are:

1.     Timing. The 1031 exchange rules include strict deadlines for identifying and acquiring replacement properties. Once the sale closes on the property in question (the relinquished asset), the taxpayer has 45 days to identify potential replacements. The investor must complete the transaction(s) within 180 days, including the first 45 days dedicated to the identification process.
2.     Use of a Qualified Intermediary. The investor can't personally have access to the sale proceeds between the initial sale and the later purchase of replacement property, and the funds can’t be available to anyone considered their agent. To ensure "arms-length" status, the property owner engages a Qualified Intermediary to handle the transactions, oversee the accounting and reporting, and control the funds.
3.     Replace cost and debt. The replacement property (or properties) must have at least the same fair market value as the relinquished asset, and the debt must also be equivalent or higher. If there is an inadequate amount of debt, the exchange will be ineligible for tax deferral.

One option Is the DST

During some economic cycles, asset financing can be challenging to obtain and slower, which could cause an investor to risk missing deadlines in the tight time frame of a 1031 exchange. Therefore, investors looking for an option to complete their deal with a specific level of debt may want to consider exchanging into a Delaware Statutory Trust, or DST.

A DST is a pre-packaged investment that investors can buy in customized amounts, typically with low minimums. DSTs cover a range of commercial properties across all sectors and offer access to passive income and tax advantage potential with professional portfolio management. Since 2004, the IRS has deemed DST products eligible for 1031 exchange on both entry and exit, increasing their appeal for investors in a time crunch or struggling to replace value or debt within the exchange process. However, these investments have risks and rewards, including liquidity considerations. Always consult your financial advisor.