To successfully complete a 1031 exchange, an investor must adhere to specific requirements outlined by Internal Revenue Code Section 1031. To summarize, an investor must purchase a like-kind property that is equal to or greater than the net sale price of the property sold. A like-kind property is any property held for productive use in a trade or business, such as income property, or property held for investment.
One common misconception is that an investor must only replace the proceeds of their sale; however, it’s important to clarify that both equity and debt must be replaced. Therefore, if an investor sells a property for $2 million, but they have outstanding debt of $500,000, they must still purchase a property equal to or greater than $2 million. An investor in this scenario has the option to either use their proceeds and obtain a loan to replace the outstanding balance, or they can replace the $500,000 with personal funds. Most investors opt to replace their debt.
With today’s high interest rates and tightening lending requirements, some investors are challenged with replacing their debt in exchange. For example, some are unable to obtain a loan, while others are only able to obtain a loan that puts them negatively leveraged in their investment. Neither of these options is desirable for a real estate investor.
Thankfully, there is an alternative solution that can potentially help real estate investors replace their debt. Through investing in Delaware statutory trusts (DSTs), investors can access institutional quality assets while leveraging the loan obtained by the sponsor.
How can investors use DSTs to replace their debt?
When an investor purchases fractional ownership in a Delaware statutory trust, they are assigned their fraction of debt as well. For example, if a DST is offering a property that has a 30% loan-to-value when the investor invests $350,000, they will be assigned $150,000 in debt, bringing their total purchase price to $500,000. Per the IRS, this investment would meet the requirements for any exchange where the relinquished property is sold for equal to or less than $500,000.
In the case of a DST, the investor never has to obtain the lending on their own. Rather, the sponsor secures financing prior to the capital raise, and the investor then has access to the terms approved by the lender. Generally, a sponsor’s transaction history and relationship with lenders make them privy to more preferable terms than an individual investor can attain. In an environment such as today, this access can be beneficial to investors looking to replace debt.
Additionally, the debt is non-recourse, and an investor has limited liability—the DST is structured so that investors are protected from personal liability beyond the amount of their investment.
