We often come to hear that while doing a 1031 property exchange that the previous mortgage balance must be replaced. This is referred to as the debt replacement principle. This means that your replacement property’s new mortgage must be equal to or more than the amount owing on the surrendered property. If the new mortgage is lesser than the old one, you will have a choice to pay down the leftover debt with a cash contribution.
By adopting the debt replacement concept, you can increase your chances of deferring 100 percent of your capital gains taxes. Let’s have a look at a simple example of the procedure. The purchase price of a replacement property that qualifies as a like-kind property for a 1031 exchange must be equal to or greater than the net sales price of the relinquished property. As an example, if you sold a home for $300,000 but had to pay $10,000 in closing expenses, your net sales price is $290,000. To be considered like-kind, a replacement property must be worth at least $290,000.
If you owed $100,000 on the relinquished property at the time of sale, you must repay that amount when the property is sold. You will have $190,000 in cash after repaying the loan, which you can use to buy a replacement property that costs at least $290,000. You must make up the difference, so you will either take out a new loan for the remaining $100,000, contribute an additional $100,000 in cash, or use a mix of additional contributions and financing to bridge the gap. You have followed the debt replacement concept regardless of the approach you used to fund the entire purchase price.
How do I replace debt if I plan on getting a controlling interest in a Delaware Statutory Trust?
You might be wondering how this debt replacing principle applies if you plan to buy a portion of a property controlled by a Delaware Statutory Trust (DST) as your replacement property. DSTs acquire replacement assets by purchasing beneficial interests in the DST. You pay a specific amount to the DST’s sponsor, and in exchange, the sponsor assigns you a certain amount of the trust’s interest.
The problem now occurs when you find you can’t get a loan to buy trust interests. If you only have $190,000 in cash, you can’t buy interests for $290,000 to qualify as like-kind property (as in our previous scenario). Or do you think you can?
DSTs are designed to assist investors achieve their like-kind requirements by maintaining varied loan-to-value ratios. When the DST buys a home, it finances a portion of the purchase price. As a result, when an investor buys a DST interest, they not only get a piece of the property, but they also get a piece of the debt.
The typical loan-to-value ratio for DST loans is between 45 and 65 percent. In our scenario, the investor would seek out a home within a DST with a loan-to-value ratio of around 35 percent, assuming the investor was not aiming to trade up or raise the value of the investment. Investors, on the other hand, frequently attempt to perform a 1031 exchange in order to trade up. In that instance, the investor would likely seek a DST with a greater loan-to-value ratio, such as one between 45 and 65 percent.
An investor who invests $190,000 in cash to purchase interests in a DST with a 45 percent loan-to-value ratio and a $25,000 per interest offer would receive a part of the loan in the amount of $156,000. This works out to $346,000 in total purchase value, or 13.84 interests. This investor would own 11.5 percent of the property if it had a total worth of $3 million.
- $3 million in property value
- $1,350,000 in total debt (45 percent loan-to-value ratio)
- $190,000 in cash from the investor
- The investor’s share of the debt is $156,000. (45 percent loan-to-value ratio)
- $346,000 is the value of the investor’s investment.
- 5 percent of the property is owned by the investor.
To fulfill the demands of most investors, each DST is structured differently, with varied loan-to-value ratios. If the investor in our example wanted to get rid of debt commitments, he might have looked for an all-cash DST with no loan-to-value ratio. In this situation, he would provide additional funds to complete the acquisition, ensuring that the replacement property is of similar or better worth than the relinquished property.
Consider the advantages of having a DST investment for your replacement property, regardless of the loan-to-value ratio on your current investment property. Allow us to assist you in locating a DST that matches or exceeds that ratio, allowing you to meet the like-kind requirements for your 1031 exchange.