Matching the debt from the relinquished property is a vital requirement of the IRS during a 1031 exchange. Failure to do so will result in paying taxes — the worst-case scenario for a 1031 exchanger. But when the markets become unstable or a recession sets in, securing a loan for the replacement property in the exchange may become difficult or even impossible. A paper published by the Harvard Journal of Financial Economics notes that during the peak of the Global Financial Crisis (Q4 of 2008), new loans to large borrowers fell by 47% compared to the previous quarter and by 79% relative to the peak of the second quarter of 2007, identified as the peak of the credit boom.
While the full impact of Covid-19 on the economy and real estate investments remains to be determined, and transaction activity, as reported by Real Capital Analytics, took a sharp drop in the second quarter of 2020, many investors report significant impact to their 2020 and future real estate investment strategy. For some, this means increased purchases, while others will stay on the sidelines or sell. For those investors planning to add to portfolios, particularly with the regulatory constraints attendant on a 1031 debt exchange, financing may prove intractable. Rob Weil, with JDI Realty LLC, points out that borrowers who had multiple financing options prior to the pandemic are looking at limited choices today. Lenders may be imposing more stringent underwriting requirements or charging a premium for expansive guidelines.
The amount of debt attached to the replacement property must equal or exceed the debt eliminated with the relinquished property in the exchange (along with the other requirements). As a result, investors in the property selection phase of a 1031 deal may end up running out of time, caught up in the tight time frames of the IRS rules. If you miss the identification or acquisition deadline, you lose the tax advantage.
One attractive option may be a Delaware Statutory Trust or DST. The IRS approved DSTs as a vehicle for completing a 1031 exchange in 2004. Since then, they have grown in popularity to become the primary instrument used for pooled investments by investors seeking to defer taxable gains. Before the approval of DSTs, TICs (Tenants -In-Common) was the most widely used structure for multi-investor opportunities. TIC investment groups lost favor during the Global Financial Crisis due to the investors' shared authority and equal power, which made decision-making and accountability difficult. Lenders were hesitant to continue making loans on the complex arrangements. With a DST, there is one borrower, and the trust has one decision-maker, a trustee, rather than as many as 35 investors needing to agree on major decisions in a TIC structure. The individual investors’ credit information is not relevant to financing of DSTs, and any delinquency does not affect an investor’s credit. Only the sponsor or trustee is directly involved in credit and financing.
From the investor perspective, the speed of completion is a significant advantage. DSTs are easier to select and invest in than direct properties tend to be. So when an investor is under a time crunch and trying to move quickly (despite the IRS-mandated 1031 exchange extension), they can select, invest in, and close on a DST within a matter of days. These assets can provide a great deal of simplicity in a complicated and uncertain situation, helping to alleviate stress for the investor. However, the investor can retain the advantages of direct property ownership. The DST portfolio can include diverse properties—multi-family housing, strip centers, other retail, and industrial, among others.
Remember, equivalent debt is only one of the essential requirements of a 1031 exchange. The replacement property must also be a "like-kind" property compared to the relinquished asset, and the price must equal or exceed the cost of the property sold. Always consult your tax advisor.