Do You Know How Debt is Treated in a 1031 Exchange?

It may be unwise to buy a replacement property until you know how debt is treated in a 1031 exchange.

Are you planning to replace your current investment property for something larger? Perhaps you want to reinvest in a better location or simply diversify your holdings? If so, an exchange under IRC §1031 may be a good way to defer taxes while potentially improving the quality of your real estate. In a 1031 exchange, a taxpayer may defer all capital gains taxes on the sale of a property if (1) the relinquished property is held for investment or business purposes, (2) funds are sent directly to a qualified intermediary at the close of escrow, and (3) the replacement property is used for investment or business purposes. The replacement property must be identified within 45 days and purchased within 180 days from the close of sale of the relinquished property.

To defer all the capital gains taxes, the replacement property must be equal to or greater in value relative to the original property. That math is easy when there was no loan on the relinquished property–but what happens where there is a loan?

Let us consider the following example: An investor sells an investment property for a net sales price of $1,000,000 (total sales price minus allowable closing costs). As a result, $1,000,000 is the amount of real estate the investor must purchase if they want to defer all the capital gains tax on the sale. Now let us assume that, before the property was sold, there was a loan on the property for $400,000.  Here, the loan would be paid off at close of escrow and the remaining funds of $600,000 are available for the investor’s next purchase. How much real estate must the exchanger purchase in the exchange?

The answer is still $1,000,000–even through the investor only has $600,000 of equity to invest. The deficit can be made up with either a new loan or cash, but ultimately the investor must purchase $1,000,000 of replacement property to defer all the capital gains taxes. Discovering this after an investor has already sold an investment property can create stressful, timeline problems if the investor has a difficult time obtaining a new loan at reasonable terms–or cannot obtain a loan at all. Indeed, obtaining replacement financing can be one of the most difficult obstacles for clients seeking to complete a 1031 exchange.

One possible solution: purchase one or more Delaware Statutory Trusts (DSTs) as a replacement property. Most DST properties are offered with pre-arranged, built-in loans for which the investors need not qualify or even apply. An equity investment of $600,000 cash into a DST that has a 40% LTV would result in the investor being allocated a $400,000 loan amount for tax accounting purposes. Going back to the example above, this allocation would satisfy the $400,000 of debt the investor needs to replace in their 1031 exchange. Again, this happens without the investor applying for or even signing for a loan. The investor does not make loan payments directly and is generally not held personally liable for the loan. Of course, using debt financing comes with risks. As with any real estate debt, if the loan is not paid, the bank could foreclose on the property, which would have an adverse effect on the DST investors.

To learn more about the strengths and weaknesses of using DST debt in a 1031 exchange, view our free fact sheet here, “DST Debt 101”.

If you have any questions, we would love to talk with you. To schedule a call with one of our Advisors, Click here: https://1031capitalsolutions.com/contact/

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Because investor situations and objectives vary, this information is not intended to indicate suitability for any particular investor.

This is for informational purposes only, does not constitute as individual investment advice, and should not be relied upon as tax or legal advice. Please consult the appropriate professional regarding your individual circumstance.

IRC Section 1031, IRC Section 1033 and IRC Section 721 are complex tax concepts; therefore you should consult your legal or tax professional regarding the specifics of your particular situation.

DST 1031 properties are only available to accredited investors (typically defined as having a $1 million net worth excluding primary residence or $200,000 income individually/$300,000 jointly of the last three years; or have an active Series 7 General Securities, Series 82 Private Securities representative, or Series 65 Uniform Investment Advisor Law. Individuals holding a Series 66 Uniform Combined State Law do not fall under this definition) and accredited entities only.  If you are unsure if you are an accredited investor and/or an accredited entity, please verify with your CPA and Attorney.

There are material risks associated with investing in DST properties and real estate securities including liquidity, tenant vacancies, general market conditions and competition, lack of operating history, interest rate risks, the risk of new supply coming to market and softening rental rates, general risks of owning/operating commercial and multifamily properties, short term leases associated with multi-family properties, financing risks, potential adverse tax consequences, general economic risks, development risks, long hold periods, and potential loss of the entire investment principal.