What Is Debt Replacement in a 1031 Exchange, and How Does It Work?

Posted Aug 16, 2021


A 1031 exchange is a transaction that enables investors to use the proceeds from one investment property to fund the purchase of similar (like-kind) replacement property while deferring the payment of capital gains taxes and depreciation recapture. The name 1031 exchange refers to the IRS code section that established the practice, which was initially intended as an actual land exchange but today is used for investment property.

There are several crucial steps in the successful completion of a 1031 exchange:

  1.     Plan ahead. Since the IRS has created a short deadline for identifying and purchasing replacement properties, taxpayers should start looking for candidates before selling the property targeted for disposal. When the real estate market is tight, finding appropriate "like-kind" assets can be challenging. Don't let a delay end in failure.
  2.     Find and engage a Qualified Intermediary (sometimes called an Exchange Accommodator). The IRS rules prohibit the investor from handling any sale proceeds, so it's critical that you have the QI ready to receive the funds from the asset sale.
  3.     Identify potential replacement properties within 45 days of the close of the sale on the relinquished property. Then, consummate the replacement asset purchase (through the QI) within 180 days, inclusive of the first 45 designated for identification of properties.
  4.     Arrange for acquisition financing. This part of the process is where debt replacement comes into play. Matching the debt from the relinquished property for the newly acquired property or properties is essential for the 1031 exchange to be successful. If the exchange fails, the investor will have to pay the taxes on the gain, and the effort and funds expended in buying the replacement property will have been pointless. But during some economic periods, financing property can be burdensome, made more so by strict underwriting guidelines or costly fees.

Debt Replacement Requirements Highlight the Potential Advantage of DSTs for 1031 Exchanges

As noted, execution of a 1031 exchange must proceed according to strict timelines to meet the IRS requirements and successfully allow for the deferral of the capital gains taxes due on the sale of the investment property the taxpayer has relinquished. Failure to identify or complete acquisition will disqualify the transaction, as will an inadequate debt replacement load. The debt of the replacement property or properties must be equal to or greater than that of the relinquished property for the exchange to be eligible for tax deferral.

An investor faced with pressure to complete the transaction and perhaps challenged in identifying suitable "like-kind" assets or appropriate financing may consider acquiring shares of a Delaware Statutory Trust (DST.) Since DSTs are pre-packaged and customizable with minimum investment amounts (for accredited investors), the strategic taxpayer can pursue the investment amount and debt load they seek and may be able to move more quickly than would be likely if they were directly purchasing individual assets. In addition, since the DST financing is not affected by the credit situation of the individual investors (shareholders), their participation does not delay or alter the debt arrangements. This availability can simplify the exchange process for the investor.

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. Costs associated with a 1031 transaction may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities. No public market currently exists, and one may never exist, for the interests of any DST program.

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