Many investors enter a 1031 exchange with the intention of deferring their capital gains taxes. However, if you had a mortgage on your relinquished property, the exchange process is a bit more complex.
Successfully completing a 1031 exchange requires you to follow a specific set of rules, as outlined in Section 1031 of the U.S. Tax Code. This includes the requirement to purchase a replacement property that is of equal to or greater value than the relinquished property.
To meet this requirement, you must not only reinvest net proceeds you receive from the property sale, but also replace any mortgage debt that was paid off when the relinquished property was sold. In the current lending environment, many investors have found it difficult or impossible to acquire the loans they need to satisfy the debt replacement for their exchange.
The good news is, there are other options. One of them, which we will discuss below, is replacing your relinquished property with a Delaware Statutory Trust (DST) which can allow you to easily meet your debt replacement requirement and successfully complete your 1031 exchange, should you meet the necessary accreditation requirements and should it be suitable for you and your needs.
To clarify exactly how the debt replacement requirement works, take a look at this example.
If a hypothetical investor sold property for $450,000 and they had a $150,000 mortgage loan, they would receive roughly $300,000 in cash upon completion of the sale. To complete a full exchange and receive deferral of their capital gains taxes, 1031 exchange rules dictate that they would need to reinvest a total of at least $450,000.
If they directly purchased a replacement property, they would need to use the $300,000 cash they received from the sale of the relinquished property and either borrow $150,000 or contribute an additional $150,000 of their own funds. Both of these options can create a roadblock for investors, particularly now that borrowers across the United States are facing a lending crunch.
In the past, using our previous hypothetical sellers and exchangers, as long as their credit was good and they had enough income to meet their loan payments, getting a mortgage to satisfy the 1031 exchange debt replacement requirement typically wasn’t much of a problem. However, in today’s environment, many investors are finding that this is no longer an option.
With big mortgage players, such as Wells Fargo, shrinking their mortgage footprints and others tightening qualification requirements, some investors are unable to access traditional mortgage loans, making it difficult to successfully complete a full 1031 exchange. However, all hope is not lost. If suitable, accredited investors may utilize a Delaware Statutory Trust (DST) as an effective strategy for meeting the 1031 exchange debt requirement without the need to acquire debt directly from a lender.
DST’s are passive investments and lenders deal directly with the trust, allowing the DST to take on the necessary debt and freeing investors from having to secure a loan themselves. Since debt is typically already prepackaged on the investment, purchasing part of a DST can help you meet the debt replacement requirement, even down to the penny.
Choosing the right replacement property to meet your debt obligations can be confusing, so consider consulting with an experienced professional before making a purchase. If you’re interested in learning more, please schedule a consultation with us here.
Because investor situations and objectives vary this information is not intended to indicate suitability for any individual 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.
Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.
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.
DST 1031 properties are only available to accredited investors (typically have a $1 million net worth excluding primary residence or $200,000 income individually/$300,000 jointly of the last three years) 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.