Last week as you read about the necessity of adhering to the Debt Replacement Principle when completing a 1031 exchange, you may have had one important question running through your mind: “Can I obtain debt to meet my 1031 exchange requirements if I invest in a Delaware Statutory Trust (DST)?”
If you missed last week’s post, the debt replacement principle requires a 1031 exchange investor to either take out a new mortgage with a value equal to or greater than the amount owed on the relinquished property at the time of sale or replace the previous amount of debt with an additional cash contribution.
Many investors have asked this question about debt, and many mistakenly believe that the only way to meet the debt replacement principle when investing in a DST is to contribute cash out of pocket to replace the previous amount of debt. If that were the case, most investors would not have the resources to complete their 1031 exchange with a DST as the replacement property.
The good news: DSTs are set up to accommodate investor debt needs. This is possible because DSTs are considered “pass-through entities.” As pass-through entities, all finances pass through the DSTs to the investors, or beneficiaries. Each beneficiary receives their portion of the cash flow, the expenses, and the debt.
This is how it works. When a DST acquires a property for $10 million, mortgaging 50% of the property, or $5 million, each share of beneficial interest purchased by an investor will also have a 50% loan-to-value ratio. In other words, a share of beneficial interest in the DST valued at $25,000 will only cost the investor $12,500 in cash because the remaining $12,500 will be assigned to the investor as debt. Therefore, if an investor has $350,000 in cash to reinvest, they would receive 28 shares of beneficial interest in the hypothetical DST and $350,000 in debt. That investor would have a total investment value of $700,000 and 7% ownership of the property.
Average DST loan-to-value ratios range between 45% and 60%. It is important to note the loan-to-value ratio of any DST you are considering to ensure it will meet your debt requirements.
The better news: When investors acquire debt as a beneficiary of a DST, they neither have to qualify for the loan nor take responsibility for the loan. The investors do not have to submit financial background information to the mortgage lenders or worry that some unexpected hurdle will block their financing. The loan will not appear on their credit scores. And in the unlikely event that the loan becomes delinquent, the delinquency will not affect the investors’ credit.
Instead, the investors receive many loan benefits. The debt amounts increase their investment values. The loans meet the 1031 exchange debt reduction principle requirements. And investors receive 1098s, which can be used to apply their portions of the loan interest payments to their tax write-offs each year.
So to answer the above question, “Can I obtain debt to meet my 1031 exchange requirements if I invest in a DST?” Yes. Not only will most investors be able to meet their 1031 exchange debt requirements when investing in a DST as a replacement property, but they will receive many benefits of convenience when they invest in a property where the financing is already in place.
For more information on determining and meeting 1031 exchange debt requirements, see Taking the Stress Out of Debt