You must have heard to complete a 1031 property exchange, an investor needs to replace the previous mortgage value. This is known to be the debt replacement principle. In simple terms, the debt on your replacement property must be equal to or greater than the mortgage on the relinquished property. In case your new property has less debt, you must offset the difference with an additional cash contribution.
By following the debt replacement principle, you can be sure that your exchange will qualify, and you will be able to defer 100% of your capital gains tax. Let’s consider this basic example of the process.
For your replacement property to qualify as a like-kind property for a 1031 exchange, its purchase value must be equal to or greater than the net sales price of your relinquished property. Therefore, if you sell a property for $300,000 and pay $20,000 in closing costs, the net sales price will be $280,000. Your replacement property must be of at least $280,000 to qualify as like-kind.
Let’s elaborate on the above-mentioned example. Say you had $100,000 debt left on the relinquished property at the time of sale. In that case, you must repay the debt when the property is sold. Once you repay the debt, you will have $280,000 in cash to buy a new property worth at least $380,000. You must find a way to cover the deficit. One way is to opt for a new loan of $100,000 or pay $100,000 in cash. You can also use some other financing combination to cover the deficit. Whatever you choose to pay the deficit, you’ve followed the debt replacement principle.
The importance of the debt replacement principle is to ensure that your new property’s value qualifies as like-kind. In no way, it creates an additional 1031 exchange requirement to qualify the loan amount.
How can I replace debt when investing in a Delaware Statutory Trust?
If you want to acquire a DST (Delaware Statutory Trust) property as your replacement property, you may think about how the debt replacing principle will impact your transaction. You can acquire a DST property by purchasing a DST’s shares. You pay the DST Sponsor a certain amount, and in return, the Sponsor assigns you a fixed interest in one of the DST properties.
There is a condition, though. You can’t get a loan to purchase interests in a DST property. You may also no be able to invest your sale proceeds of $380,000 in the DST as you only have $280,000 in cash.
DSTs maintain several loan-to-value ratios to help investors fulfill the IRS like-kind requirement. Every time a DST purchases a property, a particular portion of the property is financed. Therefore, your investment in a DST not only gives you a fixed interest in its property but also in the loan.
On average, DST loans range between 45% and 65% loan-to-value. In the above-mentioned example, the investor would acquire a DST property having a nearly 35% loan-to-value ratio, provided the investor does not trade up or change the value of the investment. However, mostly, investors do a 1031 exchange so that they can trade up. If that happens, the investor must invest in a DSThaving nearly 45-65% loan-to-value ratio.
Every DST is designed uniquely depending on loan-to-value ratios to meet investors’ needs. In the previous example, if the investor wanted to remove debt obligations from the investment, he may have found an all-cash DST without any loan-to-value ratio. In this case, he would pay additional cash to complete the purchase, qualifying the replacement property is equal to or greater value than the sold property.
Irrespective of the loan-to-value ratio on your current investment property, you can invest in a DST to obtain all the benefits. Let us help you find a DST to match your ratio so that you can complete your 1031 exchange.