DST - debt vs debt free

Frank Jiang

Investor · San Diego, CA · Member since 2014 · 592 posts · 765 votes

6y

There's a debt fulfillment requirement for a 1031 exchange. If you 1031 a property that had a mortgage, you need to exchange that for a property with an equivalent amount of debt. DSTs are pass through entities, just like LLCs, meaning that if you have a debt fulfillment requirement, a DST can help meet that need. If that DST has 10M in assets and a 5M loan, it has an effective 50% LTV for the purposes of fulfilling the debt equivalent exchange.

Very simple example:

You sell a 1M rental with 50% LTV. You gain 500K in cash. If you want to 1031 this 500K, you need to purchase 1M worth of real estate and have 50% LTV on the repurchase. If you invest in a DST worth 10M with 50% LTV, you would receive a 10% equity share of the DST with 1M in assets and 500K in debt from an exchange perspective.

Jessica Singh

OP

Member since 2020 · 39 posts · 10 votes

6y

@David M. : Thx. Made a note to check who gets paid first when DST is over & when DST falls short of capital.

@Frank Jiang: for this example, we are considering that there is no debt on the property being sold. No debt requirement to carry forward.

Would one invest in debt free DSTs or into DSTs with about 49-50% LTV. Which is a better idea and why?

Real Estate Broker · Portland, OR · Member since 2019 · 4k+ posts · 2k+ votes

6y

Would one invest in debt free DSTs or into DSTs with about 49-50% LTV. Which is a better idea and why?

Usually they structure them assuming people buying are in 1031s.

In that case for 100% deferral, buyer has to meet/beat price, equity and debt. No perfect number, but 50% debt probably works for most people.

The only way I'd do debt free, is if I was buying something that wasn't generating income like raw land. Have no clue why I'd buy raw land in a DST (or if you can get them), but that's it.

Tony Kim

Rental Property Investor · Los Angeles · Member since 2018 · 844 posts · 1k+ votes

6y

Originally posted by @Jessica Singh:

Assuming I no debt on my incoming gains from selling a rental property, what are the advantages of opting for DSTs with almost 50% LTV vs debt free DST?

A. If we take say 50% LTV, what happens after 10 years when DST comes to term? Won't I now have a debt that will need to be carried forward into the next exchange?

B. If we take a debt-free DST. After 10 years, I won't have any debt to carry forward.

Can anyone help by giving an example with what happens to 100K cash (debt-free) available for 1031, to be invested in a DST with COC 5%. in DST-A vs DST-B

As I understand, for 10 years, both DSTs will give $5000/year. Also, will this interest income be tax-free in both DSTs. Is that a simple answer, if not, ignore this question.

What happens if both DSTs get sold for 200k. Does debt play any role in how much money I get to reinvest?

I am asking this due to my preconceived notion that debt is always bad. Please educate me if my understanding is wrong. Ready to learn. Thank you!

This is a very good question and one that I hadn't considered back when I was looking at DST's. So the main concern is if you invest in a DST with 50% LTV, when that investment's cycle ends, you will have to worry about debt replacement in order to avoid boot when you make your next exchange. Essentially, you'd almost be "wasting" a debt-free exchange. From a cash-flow perspective, like you said they are equal. But you also have to keep in mind there will be a minor benefit to the leveraged DST at the end of the cycle because you will be benefiting from 10 year's worth of loan payments whereby some will be applied to principal. However, I don't think it will be that much, and probably not worth the burden of suddenly having to worry about debt replacement going forward though. If they both have the same pro forma cash flow, I would 100% invest in the debt-free DST.

However, I do seem to remember reading a post by @Dave Foster recently that debt replacement was not necessary as long as you come up with additional money to cover the amount that would normally have been covered by financing. I could be wrong though and I apologize in advance to Dave if that's the case.

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Real Estate Broker · Portland, OR · Member since 2019 · 4k+ posts · 2k+ votes

6y

Originally posted by @Tony Kim:

you will have to worry about debt replacement in order to avoid boot when you make your next exchange.

Well, usually they structure DSTs to last for 7+/- years and the loan lives that long also.

Your interest rate-risk would be the same for any property you hold/sell for the same period if you do a 1031 then.

However, the hope is your loan balance would drop.

Dave FosterBusiness Member

Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes

6y

@Tony Kim, absolutely correct. The requirement for a 1031 is only that you purchase at least as much as your net sale and that you use all of the proceeds in the purchase of the replacement. So in @Jessica Singhs situation as long as she spends all of the cash in her exchange account she will have deferred all tax.

But here's where the DST option becomes a little more interesting. In general debt does equal risk. So the absolute safest play is to do a 1031 with cash and no debt. I don't know of any debt free dsts off the top of my head. Debt free offerings of tenant in common projects are fairly common. The reason is that dsts cannot refinance debt. So if they want debt as a safety net or for value add or whatever it has to be in place at the outset.

But what's really interesting about dst debt is that it adds to your your % ownership of the property (the trust). But you don't have to qualify for it. And it is non-recourse to you personally. So for a 1031 investor selling a piece of property with debt on it they can turn the debt from recourse into non-recourse without having to qualify. The debt disappears from their personal balance statement.

DSTs typically make the cash flow payments on the amount of cash invested. But the debt you assume becomes part of your purchase. So in Jessica's case, if her sale was $500K she would get payments from the trust based on the $500K. But if it was leveraged 50% she would have ownership of $1 mil of the trust. So her appreciation will be greater as well as receiving the benefits of the amortization of the debt and the depreciation write off.

Dave Ramsey is my spirit animal. But inbetween being debt free or having a rolling case full of credit cards, the debt from a dst is relatively secure and can be beneficial.

The down side is that when the dst sells you are selling $1 mil worth of the trust so your reinvestment target becomes much higher - true. But that is no different than Jessica using her proceeds as down payments on multiple properties. Added debt equals the benefit of debt and the leverage of buying more. But it also brings with the the requirement to then reinvest more. This isn't an exact number because it will depend on loan terms. But if a DST goes full cycle over 5 years with 5% debt on that $500K it could return almost $100K of amortization payments. And remember those payments didn't come from the client. They came from operation of the project.

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David M.

Morris County, NJ · Member since 2020 · 5k+ posts · 2k+ votes

6y

@Dave Foster

So to clarify, there is no debt fulfillment requirement for 1031?

Frank Jiang

Investor · San Diego, CA · Member since 2014 · 592 posts · 765 votes

6y

Originally posted by @Jessica Singh:

@Frank Jiang: for this example, we are considering that there is no debt on the property being sold. No debt requirement to carry forward.

Would one invest in debt free DSTs or into DSTs with about 49-50% LTV. Which is a better idea and why?

I think your question has been answered in this thread, but I'll submit a direct and succinct answer to your question:

- Debt Free DST PRO: you will not have a debt fulfillment requirement when doing your next 1031 out of the DST.

- 50% LTV DST PRO: the returns on this DST will likely be better. Just like with any other income producing asset, debt accelerates the rate of return and increases your equity share in the DST.

If your rate of return on both DSTs is expected to be equal even after this debt, I would choose the Debt Free DST for additional flexibility on your next 1031.

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Dave FosterBusiness Member

Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes

6y

@David M., Not specifically. The two requirements to fully defer all tax are that you purchase at least as much as your net sale (contract price minus closing costs and commissions). And that you use all of the net proceeds (net sale minus mortgage payoff) in the replacement purchase.

Where that money to cover the difference between net proceeds and net purchase comes from is irrelevant to the IRS. It could be a new loan. Or it could be cash from yourself. Or it could be assumed debt in a DST. Most folks don't have access to cash of their own. So they end up taking a new loan. But it is not a requirement.

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David M.

Morris County, NJ · Member since 2020 · 5k+ posts · 2k+ votes

6y

@Dave Foster

That's what I thought. Thanks.

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Paul MoorePro Member

Commercial Real Estate Fund Manager · Lynchburg, VA · Member since 2015 · 1k+ posts · 1k+ votes

6y

@Jessica Singh, you got some wonderful advice here. I would love to hear what you decided. As @Dave Foster said, the benefit to this DST debt is that it can give you double the appreciation as well as some more (say 30-40%?) more cash flow along the way. And as @Account Closed said very wisely, most DSTs are the beginning of a series of passive 1031 exchange investments. And I agree, with Chad that there are indeed debt-free DSTs out there. It should not be that hard to find one.

Real Estate Broker · Portland, OR · Member since 2019 · 4k+ posts · 2k+ votes

6y

For full 1031 deferral, you need to meet/beat 3 things:

1) Price (same or higher)

2) Equity (same or higher)

3) Debt (same or higher)

This is probably more a drive of how much leverage the DST takes on is what the buyers want/need.

Dave FosterBusiness Member

Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes

6y

@Steve Morris, One correction to your 3 points. 1 and 2 are right on. But number three is not a requirement. There is no requirement to have the same or greater debt on the new property in a 1031. It is perfectly fine to replace debt with your own cash so the new property has not debt.

But... #s 1 and 2 basically ensure that #3 happens. You will either have debt (which most people do) or you will have used your own cash to replace the debt.

You're absolutely right that this is a driver of the DST purchase function. The client looks for how much of a property their cash will purchase. As long as their cash will buy an interest that is equal or greater than their net sale because of the assumed debt they will defer all tax . In the OPs scenario they have the ability to take on a much greater ownership using debt and all of their cash proceeds.

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Real Estate Broker · Portland, OR · Member since 2019 · 4k+ posts · 2k+ votes

6y

It is perfectly fine to replace debt with your own cash so the new property has not debt.

OK, I stand corrected.