Introduction
The increase in retiring landlords has led to a surge in 1031 capital flowing into passive solutions like Delaware Statutory Trusts (DST) and Tenants-In-Common (TIC). These investors are typically drawn to the turnkey nature of 1031 solutions, investing in high-quality real estate with potential passive income. With rising interest rates and more conservative lending criteria from banks, purchasing real estate independently has become more challenging. Consequently, more investors are turning to DSTs and TICs to access debt more easily for their transactions. This article aims to educate readers on using debt in DSTs and TICs to meet their 1031 requirements. The information provided should not be considered tax advice. It is crucial for investors to consult their CPA or tax advisor regarding their specific situation before conducting a 1031 exchange.
IRS Requirement
The IRS mandates that 1031 exchangers purchase property must be valued at or above the net sales price of the property they sold in order to defer all taxes. For example, if an exchanger sells a property for $1,000,000 with a $400,000 mortgage, escrow pays off the mortgage and sends $600,000 in cash to the qualified intermediary. This means the exchanger now has $600,000 to purchase $1,000,000 worth of property. The exchanger can add cash or obtain a loan to cover the $400,000 needed. In today’s market, individual investors find it increasingly difficult to secure loans at reasonable interest rates. Many have turned to DSTs/TICs to fulfill this need.
Qualified Non-Recourse Debt
DSTs and TICs are structured with qualified non-recourse loans, meaning investors are not personally responsible for loan repayment. Lease revenue in the DST/TIC covers the debt expense, and the real estate serves as collateral. If the property stops generating revenue, investors can lose their principal but nothing more.
The amount of debt in a DST/TIC varies, typically ranging from 0% to 85% of the total investment value (loan-to-value ratio or LTV). If the investor takes on more debt within a DST/TIC than they had against their relinquished property, they will purchase additional property, potentially amplifying their investment’s upside potential and increasing their basis for enhanced tax benefits. However, the inherent risk of debt also exists, which includes a potential reduction in cash flow or loss of principal.
Example
Suppose a property owner sold a property for a $250,000 net sales price with a $100,000 loan. The escrow company pays the bank the $100,000 loan and sends $150,000 to the qualified intermediary. The property owner now has $150,000 to buy $250,000 worth of property, equivalent to a 40% LTV ($100,000 / $250,000 = 40%). The investor must find a DST/TIC with at least a 40% LTV. If the investor puts $150,000 into a DST/TIC with a 40% LTV, they will buy $150,000 of equity, $100,000 of debt, and $250,000 of property, potentially deferring their taxes.
If the investor puts $150,000 in a DST with a 50% LTV, they will buy $150,000 of equity, $150,000 of debt, and $300,000 of property. The investor has just purchased an additional $50,000 of property using built-in, non-recourse debt, potentially increasing their potential for appreciation and providing an additional $50,000 of a new basis for depreciation. However, it also potentially increases the risk profile as well.
If the investor puts $150,000 into a DST/TIC with a 30% LTV, they will buy $150,000 of equity, $64,285 of debt, and $214,285 of property insufficient to purchase property of equal or greater value ($250,000). The $35,715 shortfall would potentially be treated as a gain and fully taxable.
Building a Portfolio
Investing in DSTs and TICs allows for diversification. Investors should ensure that the total property purchased in the portfolio is equal to or greater than the net sales price of the property sold if they wish to defer all taxes. Investors can move debt within their portfolio of DSTs/TICs as needed, consolidating debt in a single DST/TIC or spreading it across various DSTs/TICs. This flexibility enables investors to acquire the necessary debt to defer taxes and meet their investment criteria. It also allows them to select which and how much real estate they want to subject to mortgage risk.
Debt in DST vs. TIC
While both entities offer built-in, non-recourse debt, the structure differs. In a DST, investors are not on the property deed; the trust holds the title, providing protection. Investors do not need to sign for a loan or apply for a mortgage. In a TIC, investors are on the deed, and the lender underwrites each investor. A single-member LLC is created for each investor, offering protection similar to that of a DST. Investors considering a TIC should prepare for additional administrative requirements not needed for a DST.
Conclusion
Using debt in DSTs and TICs offers a strategic path for investors to meet their 1031 exchange requirements while potentially enhancing investment returns and tax benefits in a passive, diversified real estate portfolio. By understanding non-recourse debt and carefully structuring their portfolios, investors can achieve greater financial flexibility and security. However, it is essential for investors to seek guidance from qualified financial and tax advisors to navigate these investments’ complexities and align their decisions with long-term financial goals and tax obligations. Through informed decision-making and professional consultation, investors can maximize the benefits of their 1031 exchanges and build a robust, diversified investment portfolio.
Disclosure
1031 Exchange Risk
Internal Revenue Code Section 1031 (“Section 1031”) contains complex tax concepts, and certain tax consequences may vary depending on the individual circumstances of each investor. RM Securities and its affiliates make no representation or warranty of any kind with respect to the tax consequences of your investment or that the IRS will not challenge any such treatment. You should consult with and rely on your own tax advisor about the tax aspects with respect to your particular circumstances.Please note that RealtyMogul does not provide tax advice.
This article is for informational purposes only, and is not a recommendation or offer to buy or sell securities. Information herein may include forward looking statements and is for informational purposes only. Forward-looking statements, hypothetical information, or calculations, financial estimates and targeted returns are inherently uncertain. Past performance is never indicative of future performance. None of the opinions expressed are the opinions of RealtyMogul. Advice from a securities professional is strongly advised, and we recommend that you consult with a financial advisor, attorney, accountant, and any other professional that can help you to understand and assess the risks and tax consequences associated with any real estate investment. All real estate investments are speculative and involve substantial risk and there can be no assurance that any investor will not suffer significant losses. A loss of part or all of the principal value of a real estate investment may occur. All prospective investors should not invest unless such prospective investor can readily bear the consequences of such loss.
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