A 1031 exchange is a promising strategy that helps investors defer capital gains taxes while acquiring new property, but this transaction involves many rules. One important yet often overlooked aspect of the transaction is debt replacement, as it doesn’t always apply. However, for properties that do have debt, failing to replace it when acquiring a new asset can result in tax liability. Thankfully, solutions are available, including financing built for Delaware Statutory Trusts (DSTs).
In this article, we will look at how you can use DST financing to meet IRS rules when acquiring suitable 1031 debt replacement properties.
What Is 1031 Debt Replacement?
The Basics of IRS Requirements
The idea of debt replacement stems from the rules outlined by the IRS to ensure compliant 1031 exchanges. While there are many regulations, the following three requirements are significant:
- Reinvestment of All Proceeds: All of the cash from the property sale must be reinvested.
- Equal or Greater Value: Since you need to reinvest all proceeds, you can only acquire an asset that has equal or greater value than the relinquished property. Any leftover amount will be considered boot, which is taxable.
- Debt Rule: Any debt that existed on the relinquished property must be replaced with new debt or equity. Failing to match the debt will be considered boot as well, as this is the debt replacement requirement.
Challenges Involved in Debt Replacement
Securing financing is a challenge in itself. There are many requirements that investors must secure, like credit checks and personal guarantees. Qualification becomes even more challenging because of the strict 1031 exchange timeframe, which lasts only for 180 days. If you’re an investor who has retired or has high leverage, then qualification may be more rigorous, while other investors simply don’t want to take on a new personal debt.
Thankfully, DSTs have debt structures that allow you to resolve these challenges.
How DST Financing Helps
DSTs are legal entities that acquire and operate income-generating properties, which can include institutional-grade assets. Purchasing these properties often requires financing, and for DSTs, this debt is non-recourse. Investors can then step into fractional ownership where financing is already secured.
This structure means that you, as an investor, won’t need to qualify for any financing. Plus, you’re free to choose DSTs that already match your specific debt replacement requirements. For example, if you have a $300,000 debt from the relinquished property, you can simply find a DST offering that has similar or proportionate leverage. Not only does this structure remove rigorous requirements, but it also speeds up the process. You’re less likely to exceed the 180-day timeline and maintain your tax-deferred status.
DST Investing Considerations To Keep in Mind
While DSTs streamline debt replacement, this shouldn’t be the only reason you enter one. There are other factors to keep in mind to bring you closer to a successful investment.
- Sponsor Capabilities: Debt can only be paid if the underlying properties are performing well. If a sponsor isn’t capable, then this could result in financial strain that could ultimately affect your investment.
- Leverage Risks: Higher leverage increases potential returns but also magnifies risks in downturns.
Conclusion: Leveraging DST Financing for 1031 Debt Replacement
The non-recourse debt of DSTs, plus their prepackaged nature, makes them ideal for 1031 exchange investors who need streamlined debt replacement solutions. As DSTs provide ease and speed, you can quickly acquire a replacement asset that helps you avoid boot or going over the 180-day timeframe. In other words, you avoid the stress of securing a traditional loan and increase the chances of a successful investment.
Sources:
https://apps.irs.gov/app/vita/content/36/36_02_020.jsp
https://nstp.org/memberarea/federaltaxalert/2023/what-is-boot-in-a-1031-exchange
https://www.investopedia.com/financial-edge/0110/10-things-to-know-about-1031-exchanges.aspx
