Suppose you are considering using a 1031 exchange to sell an investment property. In that case, you probably know that exchange rules require you to replace the equity proceeds from your transaction with a replacement property of equal or greater value. But you may be unaware that you also need to replace the total value of any debt you have on your relinquished property to qualify for full tax deferral on capital gains from your sale.
Let’s assume you sell your investment property for $1,000,000, and you have a $300,000 mortgage. You need to find a replacement property to invest your net proceeds of $700,000 AND your $300,000 debt requirement. This can often be challenging, leaving exchangers few options. To satisfy the debt replacement requirement, you would need to come up with an additional $300,00 in cash or secure a new loan.
However, there is another option, which many 1031 exchangers have found to be an efficient approach, the Delaware Statutory Trust (DST).
The DST Advantage
In simple terms, a DST is a passive investment structure that satisfies the “like-kind” replacement property rule of a 1031 exchange and provides you with the opportunity to own a fractional interest in investment grade property managed by professional investment management teams.
A DST provides a unique advantage for exchangers because typically, debt is already secured on property held in the trust. For example, a DST you are considering might own a $30 million multifamily property with a 50% loan-to-value ratio (LTV).
Not only could this DST easily accommodate your debt replacement requirements in the example above, but it also removes all responsibility for you securing debt on your own.
Also, DSTs can differ in the types of properties owned and the amount of leverage placed on those properties. LTV ratios can range from less than 30% to 80% or more, affording you many different options to choose from for your exchange.
Perhaps the most valuable advantage of using a DST for your equity and debt replacement needs is its simplicity and convenience. Since DST property is already owned and debt is already secured, you don’t need to worry about closing on a suitable replacement property within 180 days of your relinquished property sale while also qualifying for a loan or coming up with additional cash.
A DST with leverage not only increases the total nominal value of your investment but also enables you to take a tax write-off each year for your share of the Trust’s loan interest payments.
Finally, if you acquire a replacement DST with a greater loan to value than the property you are selling, you will acquire more total real estate which will potentially increase depreciation write-offs resulting in greater tax shelter on the income you receive.
Other Factors to Consider
As with any investment, there are other factors you should consider before making a final decision to use a DST for your exchange. For example, as a passive investor, you have no control over property management decisions, as the sponsor has all decision-making authority. Also, DSTs should generally be considered illiquid investments which may require the investor to hold property for up to ten years or longer.
Please note that DSTs, like all real estate, have risks and are only suitable for investors that can afford to lose some or all of their investment. Investment returns are not guaranteed.
To better understand the Delaware Statutory Trust and determine if it is an appropriate approach for your 1031 exchange, please contact us for a free, no-obligation consultation. You can also set some time up on my calendar here.
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