You have probably heard that when you go through a 1031 property exchange it's necessary to replace the previous mortgage amount. We refer to this as the debt replacement principle. This means the new mortgage for your replacement property must be equal to or greater than the amount owed on the relinquished property. If the new mortgage is less, you must elect to replace the remaining amount of debt with an additional cash contribution.
By following the debt replacement principle, you can have greater assurance that 100% of your capital gains taxes will qualify to be deferred. Let's walk through a basic example of the process. A replacement property that qualifies as a like-kind property for a 1031 exchange will have a purchase value equal to or greater than the net sales price of your relinquished property. Therefore, if you sold a property for $300,000 and paid $10,000 in closing costs, your net sales price is $290,000. A replacement property must have a value of at least $290,000 to qualify as like-kind.
In this example, if you owed $100,000 on the relinquished property at the time of sale, that amount must be repaid when the property is sold. After the repayment of the loan, you will have $190,000 in cash to purchase a replacement property that costs at least $290,000. You have to find a way to make up for the deficit, so you'll either take out a new loan for the remaining $100,000, contribute an additional $100,000 in cash, or utilize some combination of additional contribution and financing to cover the deficit. Whichever strategy you use to finance the full purchase amount, you've followed the debt replacement principle.
This principle is meant to help you make sure your replacement property value qualifies as like-kind. It is not meant to create additional 1031 exchange requirements for qualifying loan amounts. Hopefully understanding this principle will ease some of your minds from the stress of having to follow extra 1031 exchange rules.
How do I replace debt if I plan to acquire an interest in a Delaware Statutory Trust?
If you intend to acquire a portion of a property owned by a Delaware Statutory Trust (DST) as your replacement property, you may wonder how this debt replacing principle applies. Replacement properties owned by DSTs are acquired by purchasing shares of beneficial interest in a DST. You pay the sponsor of the DST a certain amount, and in return, the sponsor assigns a certain amount of shares of the trust to you.
Now the issue arises when you realize you can't take out a loan to purchase shares in a trust. You also can't purchase shares for $290,000 to qualify as like-kind property (as in the case of our earlier example) if you only have $190,000 in cash. Or can you?
DSTs are structured to maintain various loan-to-value ratios in order to help investors meet their like-kind requirements. When the DST purchases a property, a certain amount of the property is financed. Therefore, when an investor purchases a share of the DST, they not only acquire an interest in the property, they also obtain an interest in the loan.
The average DST loans range between 45% and 65% loan-to-value. In the case of our example, the investor would look to acquire a property within a DST that maintains an approximate 35% loan-to-value ratio, provided the investor was not looking to trade up, or increase the value of the investment. However, much of the time, investors seek to complete a 1031 exchange for the purpose of trading up. In that case, the investor would probably look for a DST with a higher loan-to-value ratio, such as one within the 45-65% range.
To purchase shares of a DST that has a 45% loan-to-value ratio and is offering shares for a price of $25,000, an investor who uses $190,000 in cash to purchase shares would obtain a portion of the loan in the amount of $156,000. This would equate to a total purchase value of $346,000, or 13.84 shares. If this property had a total value of $3 million, this investor would own 11.5% of the property.
- Property Value: $3 million
- Total Debt: $1,350,000 (45% loan-to-value ratio)
- Investor's cash contribution: $190,000
- Investor's portion of debt: $156,000 (45% loan-to-value ratio)
- Investor's investment value: $346,000
- Investor's ownership interest in the property: 11.5%
Each DST is structured differently with varying loan-to-value ratios to meet the needs of most investors. If the investor in our example wished to remove debt obligations from the investment, he probably could have found an all-cash DST with no loan-to-value ratio. In this case, he would contribute additional cash to fund the remainder of the purchase, qualifying the replacement property as equal to or greater value than the relinquished property.
Whatever circumstance you have with the loan-to-value ratio on your current investment property, don't rule out a DST investment for your replacement property. Let us help find a DST to match or increase that ratio and help you meet the like-kind requirements for your 1031 exchange.