Earlier, 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)?”
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 Delaware Statutory Trust is to contribute cash out of pocket to replace the previous amount of debt. If that were the case, most real estate investors would not have the resources to complete their 1031 exchange with a DST as the replacement property.
Meet the Debt Replacement Principle
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.
Where DSTs Come in to Fulfill Debt Requirements
- 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.
- A lender deals with the trust as the only borrower, so the DST can quickly take on debt.
- Investors then agree to pay a certain cash amount and take on debt within the trust according to the loan-to-value ratio.
When you gain fractional interest in a DST, you become one of many investors paying a loan-to-value ratio.
For example, a DST acquires a property for $10 million and mortgages 50% of the property — $5 million in debt.
- Based on this 50% loan-to-value ratio, all investors will take on the same percentage of debt.
- An investor may have $50,000 in beneficial interest, but they only paid $25,000 in cash.
- The other $25,000 is assigned as debt, taken from the $5 million mortgage owned by the trust.
How do you go about meeting your debt requirements for a 1031 exchange?
1. Sell a Property
Your first step is selling a property you’d like to use in a 1031 exchange. Perhaps you sell a property for $400,000, but you had a $200,000 loan. After paying off the loan, you receive $200,000 in equity.
2. Identify Debt Requirements
According to the debt replacement principle, you need to pay that $200,000 and take on $200,000 in debt to make the 1031 exchange valid. If you fail to take on these debt requirements, you’ll have boot — money that doesn’t qualify for the exchange and receives taxation.
3. Find a DST That Satisfies Them
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.
With your $200,000 in cash and $200,000 in debt, you may take interest in multiple DSTs to fulfill 1031 debt requirements.
For example, you can find two separate DSTs with a 50% loan-to-value ratio, and contribute $100,000 to each. Generally, minimum investments for DSTs range between $25,000 and $100,000. The laws surrounding 1031 exchanges allow you to buy multiple properties, as long as debt requirements and equal or greater values are met.
Benefits of Meeting 1031 Debt Requirements with a DST
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 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.
It’s essential to note that investing in DSTs still comes with potential risks, like relying on the sponsor for continued management or economic volatility that can lead to cash flow suspensions. While accepting these risks may not be for everyone, DSTs can still be a method for meeting debt requirements in a 1031 exchange.
For more information on determining and meeting 1031 exchange debt requirements, see Taking the Stress Out of Debt.
Browse DSTs with 1031 Crowdfunding
Having access to a range of DST listings can make it easier to find the right trusts for your 1031 exchange that meet debt requirements. When you create an investor account at 1031 Crowdfunding, you gain access to our extensive marketplace of DST properties.
This quick access to listings streamlines the process of identifying exchange properties. Our team is available to help you through the process, so you can handle identification and closing in less than a week.
