One of the questions I am frequently asked by real estate investors is how financing works with Delaware Statutory Trust (DST) properties acquired through a 1031 exchange. We often only think of 1031s in terms of their simplest definition as a like-kind exchange, swapping property for property. However, all investment properties are not created equal, and it is important to look at the specifics of the properties involved, including the debt being carried on either side. 

Investors often forget the “debt replacement principle,” which requires that you obtain financing with a value/balance equal to or greater than what was owed on your previous property or add additional cash to pay off that debt at the time of the exchange. 

Failure to take into account the amount of debt owed on both the original and replacement properties in a 1031 exchange can result in a substantial tax hit if the replacement property has less debt than the original property. The difference between the debt levels is what tax professionals refer to as “mortgage boot.” Mortgage boot is considered capital gains by the IRS and taxed accordingly. Consider this example: 

The owner in a 1031 exchange sells Property A for $1,000,000, net of all costs. Property A has a basis of $200,000 and is encumbered by a $400,000 loan. At closing, the loan is paid off and the balance of $600,000 is transferred to the owner’s 1031 qualified intermediary account. To complete a 1031 exchange, the owner uses the entire $600,000 in their 1031 account to purchase Property B for $600,000. In this scenario, the owner received $600,000 from the sale of Property A and bought Property B in a 1031 exchange for $600,000. All taxes are deferred, right? Unfortunately, the owner will be taxed on $400,000 of capital gains because they did not replace the $400,000 loan on Property A with a loan of equal or greater value on their replacement property, resulting in them incurring mortgage boot. 

There are a variety of ways you can “replace debt.” In fact, you do not need to choose just one debt replacement strategy — you can replace the value through a combination of strategies. In order to replace the value of the debt on your exchange, consider one or a combination of the following: 

➢ A Cash Contribution 

You can use your own cash to offset a reduction in debt.

➢Seller-Financing Using a Carryback Note 

If the seller is willing, you may be able to negotiate seller-funded financing through a carryback note. One drawback of this strategy is that you may have to put a fair amount of money down and interest rates may be higher than in a traditional financing scenario. 

➢ A Private Money Loan 

If you are unable to qualify for a traditional loan, you may need to seek alternative financing from a private lender. Again, while this option may be convenient, it can also involve higher interest rates and fees, making it a less viable option for long-term financing. 

➢ A Traditional Mortgage Product 

This would, of course, be the most popular and cost-effective method for financing the debt replacement requirement. With a low-interest rate in place over a long period of time, a mortgage can help you maximize your cash flow over the long haul. 

Barriers to Traditional Real Estate Financing on Investment Property Acquisitions 

My personal plan is to continue purchasing and managing both local properties and non-local, strategically located DST real estate investments. However, every time I consider buying another local property with financing, I stop myself. Why? 

Because the loan process for smaller investors today, whether refinancing an existing property or buying a new one, has become an absolute nightmare. Lenders are looking for more than just good credit, strong income, solid tax returns, and career longevity. In fact, they are going to do a full cavity search on every property I have ever owned — in some cases going as far back as fifteen to twenty years. 

I met with an investor last week who cleverly referred to the current lending situation as the “Sales Prevention Team.” I couldn’t agree more. Getting a loan on investment real estate has become a huge ordeal and opportunity cost that not only takes all the fun out of buying real estate but actually makes me reconsider how anyone could invest in real estate at all. 

Aside from the currently restrictive loan environment, many real estate investors are not in a position to qualify for a traditional loan at favorable interest rates. Maybe you are a retiree using your real estate investment portfolio to fund your retirement, which could give you a nest egg for future long-term care and generational wealth-building. Perhaps you already have too many investment properties with loans. Or, maybe you value your time and understand that the commitment involved in obtaining traditional financing is simply not worth the time it takes given the size of the investment, management, and potential gains. 

Alternatively, you may be a full-time investor without a nine-to-five job and a reliable paycheck that many lenders want to see. The lack of consistent income can be a barrier to granting a mortgage loan, even if your total income would easily qualify you. 

Financing Your DST 1031 Exchange Properties 

Now contrast traditional financing for REI acquisition with the in-place, low-interest-rate financing available through the business trust structure of DST offerings, which requires zero underwritings on the part of the investor. Because the trust itself is the borrower, investors are not subject to liability beyond their investment in the trust or property. 

In fact, the business trust structure is the only legal structure that gives investors the full benefits of leverage, including interest deductions, debt replacement for 1031 exchanges, an additional basis for depreciation, and use of other people’s money for capital gains — all without the investor being a party to the loan. Even though the investor is not a party to the loan, the loan on the DST qualifies as replacement debt for a 1031 Exchange. Had the owner in our earlier example simply exchanged their $600,000 of equity into a DST with a 40% loan-to-value, they would have completed their exchange without incurring any mortgage boot. 

The financing used for DST 1031 offerings is non-recourse financing. This is a type of financing that shields the investor’s assets beyond the subject property. Should there be a major market shift resulting from a recession or depression or in the event that a tenant fails to fulfill their obligations under the lease, the lender would have no remedy other than repossession of the property itself. That means that your other assets and the rest of your portfolio are protected. 

The Importance of Timing 1031 DST Real Estate Investments 

Of course, one of the most important aspects of the 1031 exchange is the time horizon. Once you have exited from the prior property you only have 45 days to determine your replacement property. After that, you must close on the replacement property by the 180-day mark. 

One of the most time-consuming aspects of the exchange, besides locating the property and completing due diligence, is obtaining 1031 financing. If you are required to replace debt on your exchange, you could find yourself blowing your timeframe while waiting for approval from a traditional lender. This could translate into a substantial tax liability if it causes you to miss your 180-day deadline. 

Unlike starting from scratch and identifying a property, DST properties provide a readily available supply for replacement, including those with nonrecourse financing. This allows you to close on your exchange property within weeks, even before the IRS’s 45-day identification timeline. Facilitated by a 1031 qualified intermediary, you can feel confident in finding a property ideally suited to your replacement requirements. 

Troubleshooting Your Exchange with a DST and a 1031 Qualified Intermediary

There are a variety of ways that the exchange process if poorly executed, can result in taxable income that the exchange was meant to circumvent. That is why it is important to work with a 1031 exchange qualified intermediary experienced in DST offerings. Some of the problems you will avoid by choosing a 1031 DST, aside from the mortgage or debt reduction boot, include: 

➢ Cash Boot which can occur when the cash received from the sale of your property is more than the cash paid into the replacement.

 ➢ Boot resulting from sale proceeds used to pay expenses, which are not considered qualified closing costs, including damage fees, repairs, or utility fees. 

➢ Personal Property Boot stemming from the receipt of non-like-kind property including appliances, outdoor equipment, fixtures, and other items if they are not offset by equal personal property relinquished along with the property sold. 

➢ Personal Residence Boot which can occur if you take a portion of the exchanged property and use it as your personal residence. This would mean that you open yourself up to a taxable event on the portion of the property you use personally unless offset by an additional contribution. 

Any or all of these problems can be avoided through an exchange into DST real estate investments. Because your investment is considered a proportionate share, you will be able to bypass many of the problems that can undermine the tax deferral benefit and value of other 1031 exchange properties. 

Perhaps the best part of moving from your current real estate investment portfolio into a DST is the opportunity it gives you to trade your problem investment properties for management-free, fully optimized investments. Perhaps you have properties that have never produced at the levels you expected. Others may create repeated management or maintenance issues. Still, others may be poorly positioned for additional profitability as the market shifts. 

A trouble-free, properly funded 1031 DST exchange can help to ensure that your portfolio is where you want it to be, both now and in the future.

Contact us today to see how we can help you secure a management-free, income-producing investment property.