The COVID Replacement-Debt “Boot” Problem
Settling debt through a 1031 Exchange can lead to an inadvertent tax problem. But there may be a potential solution!
The other day I was writing an article about how Delaware Statutory Trusts (DSTs) can help 1031 exchanges where property values are “downsized” from a higher, relinquished (sold) property to a lower-cost replacement (bought) property. When suitable, DSTs may be helpful in soaking up what’s left, and the article covers that thoroughly.
However, invariably that topic raised another issue that commonly overlaps many 1031 Exchange scenarios, including downsize 1031s: How do exchangers handle the problem of replacing settled debt, especially when COVID-19 has substantially impacted credit markets, increasing the potential for such situations to become a tax problem.
That’s because settled-debt is still part of the 1031 Exchange calculation for determining “boot” and if taxes are due. Boot is the proceeds of a sale received through an exchange that is not invested in eligible like-kind property.
How does this work?
In the prior article I used the example of a $5 million investment property being sold and netting $4.7 million after related closing costs. In that case, for the 1031 exchange to maximize deferrals, replacement properties (including any DSTs) would need to meet or exceed that $4.7 million figure.
Let’s assume, however, this property also had $ 1 million of debt outstanding that was settled at closing. The property sold for $5 million. Closing costs were $300k, netting $4.7 million, which is then reduced to net-proceeds of $3.7 million after paying-off the $1 million mortgage.
Yet, for the full 1031 exchange deferral to be achieved, the replacement properties must total $ 4.7 million. That leaves a $ 1 million gap in funding that, if not invested in the replacement property, becomes taxable “boot” – proportionally subject to transaction taxes that can exceed 30% between federal and state obligations.
The exchanger then has several potential alternatives:
They may secure “replacement” debt on the replacement property for the $1 million;
They may source cash from personal assets for the $ 1 million;
They may use any combination of debt and cash for the $1 million; or
They may decide (or be forced) to allow a portion (or all) of the $1 million to be subject to taxes.
Option # 1 is increasingly problematic considering the COVID-19 situation, where lenders are disinclined to lend against investment property given the uncertainty of cash flow. Lenders understand that governments probably won’t perpetually subsidize renters and leases with emergency funds. The post-COVID-19 landscape presents a lot of unknowns as to how this will play out absent bailouts.
That means trying to qualify for replacement debt is very different than just a few years ago when credit flowed relatively freely. Today, loans are often approved for only a fraction of what’s requested or with added covenants to protect the lender, and increasingly they’re declined entirely.
That leaves Option #2 -raising cash. This isn’t always a ready alternative, often triggering taxes because the exchanger must sell other appreciated assets to raise the requisite cash. It’s also not as tax-efficient, functionally creating a new tax problem in order to solve the other.
Options 3 and 4 merely determine how much tax will be due or deferred.
DSTs and Replacement Debt
If suitable, DSTs using leverage may potentially rescue a 1031 Exchange from such tax problems. That’s because whatever leverage the DSTs use in acquiring their property is proportionally credited to DST investors for purposes of the 1031 Exchange, based on the loan to value (LTV) ratio of the DST.
As an example, let’s assume a DST owns several multi-family properties costing $50 million, acquired via a combination of $25 million cash and $25 million debt, or LTV of 50%. The responsibility for acquiring and maintaining the loan falls entirely on the DST and its Sponsor as non-recourse debt, for which DST investors have no liability or obligation to secure or pay.
Let’s also assume that our example exchanger above facing the $1 million replacement debt problem, likes this DST for the 1031 exchange. The exchanger may invest $1 million into this DST with a 50% LTV and receive credit for an additional $ 1 million of related, proportional property debt. The debt is already in place and requires nothing of the investor in terms of credit underwriting, qualification, or collateral. For purposes of our $5 million 1031 exchange, $3.7 million equity was invested and $ 1 million of replacement debt secured, for the total required $4.7 million (net of the $300k closing costs) to maximize the allowable tax-deferral.
In practice, we might see our example exchanger using several different levered DSTs with differing LTVs to satisfy the replacement debt requirement. That way, the $1 million in DSTs has the added potential benefit of improving the investor's diversification across different property types and geographies.
As well, because 1031s are not an all-or-nothing proposition, it’s conceivable that an exchanger might choose to do a partial 1031 mixing and matching the components discussed above, accepting a portion as taxable.
1031 Deadline Dangers & Having Backup Plans
One last benefit of DSTs is that they can be ready to go if deadlines are closing in fast and financing is falling through or unwanted on the potential replacement property. All 1031s have a 45-day deadline from the sale closing for prospective properties to be formally listed and filed, and 180-days from closing to consummate the full exchange.
That means, if financing is not secured before the 45-day deadline and only one property has been listed for the exchange, the exchanger runs the risk of creditors backing off the deal and being left with scrambling for cash to prevent a taxable event. When suitable, a potential solution can be to co-list DSTs with the appropriate LTVs alongside the property trying to qualify for financing before the 45-day deadline. That way, if lenders balk and the financing evaporates, and the deal falls through, the 1031 exchange deferrals can still be rescued with suitable DSTs.
Just the same, for the suitable exchanger who would like to be done with the obligations of carrying debt, the DST permits them an exchange where property debt is now the obligation of the DST and its sponsors, not the DST investor.
In either situation, that merits having a potentially reliable source of DSTs that are ready for exchangers to list as 45-day deadlines near. DSTs may be easily found and quickly listed, but that comparative ease of access should not be confused with investor suitability or the quality of the DST’s structure, it’s sponsor, its business plan and projections, nor the underlying real estate, and so forth.
Like any non-public investment, prudent due diligence is paramount. The investor should be aware of prospective risks and be relatively confident of the merits of the business plan, the property, the management team, and so forth. DSTs are illiquid investments in managed real estate, and care should be taken to thoroughly review programs before investing.
That is a tall order for many investors and real estate teams, especially those facing fast-approaching deadlines. It can, therefore, be helpful to align with DST professionals familiar with the DST marketplace and its constantly shifting landscape, and who will have access to a stable of pre-qualified DST programs that have been thoroughly vetted and are subject to ongoing reviews by competent due diligence professionals that do not cut corners for convenience or opportunity.
My firm, Asset Strategy, and my Broker Dealer, Concorde Investment Service, specialize in this area. For more information, contact our team!
The prior article is based on the views, experience, and opinions of Johannes Ernharth, AIFA©. Johannes has spent his career in Wealth Management and is a Senior Advisor and Mid-Atlantic Regional Director for Asset Strategy Financial Group.
This is for informational purposes only and does not constitute an offer to buy or sell any investment. 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. There are risks associated with investing in Delaware Statutory Trust (DST) and real estate investment properties including, but not limited to, loss of entire principal, declining market value, tenant vacancies, and illiquidity. Diversification does not guarantee profits or guarantee protection against losses. Because investors' situations and objectives vary this information is not intended to indicate suitability for any particular investor. This material is not to be interpreted as tax or legal advice. Please speak with your own tax and legal advisors for guidance regarding your particular situation.
Advisory Services offered through Asset Strategy Advisors, LLC (ASA), an SEC Registered Investment Advisor. Securities offered through Concorde Investment Services, LLC. (CIS), member FINRA/SIPC. Insurance Services offered through Asset Strategy Financial Group, Inc. (ASFG). ASA, CIS, and ASFG are separate companies.