§1031 Exchange Debt Replacement Challenge

One of the over­looked and mis­un­der­stood aspect of the §1031 tax deferred exchange is the require­ment to replace debt to ful­ly com­ply with the IRS com­pli­ance.

June 10, 2024

By Al DiNi­co­la, AIF®, CEPA™
DST 1031 Spe­cial­ist
NAMCOA® — Naples Asset Man­age­ment Com­pa­ny®, LLC
Secu­ri­ties offered through MSC-BD, LLC Mem­ber of FINRA/SIPC

Specif­i­cal­ly, when you sell an invest­ment prop­er­ty that had a loan in place that loan needs to be replaced. The loan may be replaced with anoth­er loan or addi­tion­al cash. There are advan­tages built into the struc­ture of a Delaware Statu­to­ry Trust (DST) if used to replace debt in a §1031 exchange. One of the chal­lenges fac­ing investors may be select­ing the right loan-to-val­ue (LTV). This becomes a crit­i­cal aspect of com­plet­ing the exchange. In finan­cial terms the LTV ratio express­es the ratio of a loan to the val­ue of the replace­ment prop­er­ty being pur­chased. Lenders may uti­lize this ratio in deter­min­ing the finan­cial aspects of the approval process for grant­i­ng a loan to a bor­row­er. Let’s take a quick look at some basic ele­ments of real estate invest­ing and inclu­sion of DSTs.

The LTV Ratio in sim­ple terms

• Estab­lish Appraised Prop­er­ty Val­ue: The first com­po­nent is to arrive at the appraised val­ue of any prop­er­ty. DST spon­sors will an appraisal on the prop­er­ties to be acquired.
• Ratio Estab­lished: The LTV ratio (amount of mon­ey request­ed to be bor­rowed) is cal­cu­lat­ed by divid­ing the request­ed loan amount by the appraised val­ue of the prop­er­ty. With a DST this may be mod­i­fied based on the amount of equi­ty to be raised by investors.
• Prac­ti­cal Appli­ca­tion: If the prop­er­ty is val­ued at $500,000 and the loan amount is $200,000, the LTV ratio is 40%.

Dynam­ics to Delib­er­ate

1. Asset or Invest­ment Goals:
   • Sta­bil­i­ty of Income: pay­ments on a loan are ref­er­enced as debt ser­vice. Income may be more pre­dictable (sta­ble) with a low­er LTV.
   • Future Val­ue or Appre­ci­a­tion Poten­tial: Investors have fre­quent­ly used a high­er LTV (with addi­tion­al risk) if investors have a goal of poten­tial appre­ci­a­tion of the prop­er­ty.
2. Tol­er­ance for Risk:
   • All Cash: With­out any loan on the prop­er­ty this would elim­i­nate any default risk on the prop­er­ty with respect to bor­row­ing. All-cash acqui­si­tion pro­vides two key ben­e­fits: (i) it removes all loan default risk, and (ii) it could pro­vide the investor (in the case of DST the Trust) greater flex­i­bil­i­ty in the exit strat­e­gy as there is no loan to pay off (poten­tial­ly incur­ring pre­pay­ment fee) if and when the prop­er­ty is sold.
   • Low­er LTV: A low­er LTV may be con­sid­ered some­what safer. The low­er LTV may result in less risk because of less lever­age.
   • High­er LTV: A high­er LTV may be con­sid­ered to have more risk. High­er lever­age which car­ries more risk may result in high­er poten­tial returns
3. Chang­ing Mar­ket Con­di­tions Regard­ing Debt:
   • Inter­est Rates: Over the past two years the change in inter­est rates will chal­lenge the cost of bor­row­ing.
   • Lend­ing Envi­ron­ment: Restric­tion on lend­ing along with bank­ing reserve require­ments may chal­lenge the investor/borrower to obtain the most favor­able bor­row­ing terms. Investors seek­ing spe­cif­ic terms for opti­mal lever­age may have cred­it issues.
4. The con­di­tion and type of Prop­er­ty:
   • Com­mer­cial vs. Res­i­den­tial: Lend­ing lim­its may be dif­fer­ent depend­ing on the type of prop­er­ty.
   • Con­di­tion and Age of Prop­er­ty: The over­all con­di­tion of the prop­er­ty may also have dif­fer­ent require­ments imposed by the lender. A brand new built prop­er­ty or  well-main­tained prop­er­ties may have a more favor­able or high­er LTV accept­ed by the lender.
5. DST Reg­u­la­tions and Struc­ture:
   • IRS Accep­tance: As long as a DST com­plies with spe­cif­ic IRS guide­lines the DSTs have been cleared to be used as replace­ment prop­er­ties for 1031 exchanges. Spon­sors have recent­ly become more con­ser­v­a­tive in the amount of debt struc­tured in a DST. The rise in inter­est rates results in less bor­row­ing (more equi­ty raised).
   • Investor Needs and Require­ments: The reduc­tion of bor­row­ing which trans­lat­ed into a low­er LTV may chal­lenge investors with spe­cif­ic debt replace­ment require­ments to ful­ly com­ply with the §1031 exchange.

Select­ing the Right LTV when Pur­chas­ing (not an exchange)

1. Estab­lish­ing the Val­ue of the prop­er­ty: If a lender is involved more than like­ly there will be the need for an appraisal of the prop­er­ty. The bank hired a qual­i­fied apprais­er to arrive at the over­all val­ue of the prop­er­ty.
2. Poten­tial Cash Flow Pro­jec­tions: If the prop­er­ty has a cur­rent rent role it may become easy to use those cash flows to mod­el dif­fer­ent LTV and the over­all ratios. The high­er the LTV the more cash is need­ed to sat­is­fy debt ser­vice.
3. Test­ing Sce­nar­ios: Finan­cial stress tests may cre­ate hypo­thet­i­cal sit­u­a­tions and poten­tial effects on income. This would be the income need­ed to ser­vice the debt on the loan. Depend­ing on your loan struc­ture, either fixed, float­ing, or adjustable, those pro­ject­ed changes should be assessed. In addi­tion, mar­ket down­turns and chang­ing eco­nom­ic con­di­tions may alter the per­for­mance of the prop­er­ty.  (Many times, spon­sors of DST will run these sce­nar­ios dur­ing the due dili­gence phase of the acqui­si­tion process).
4. Finan­cial Advice from Lenders and Advi­sors: Lenders who spe­cial­ize with spe­cif­ic asset class may pro­vide addi­tion­al insight guid­ing investors with the under­stand­ing of loan options. This would include loan terms, LTV ratios as well as any con­ver­sion options and pre-pay­ment penal­ties.
5. Investor Risk Pro­files: Indi­vid­ual investors (apply­ing for a loan) will eval­u­ate invest­ment goals and asso­ci­at­ed risks.  DST investors and more con­ser­v­a­tive investors may con­sid­er or pre­fer low­er LTVs. 
6. Required Mini­um LTV: When an investor is sell­ing one prop­er­ty with a loan being paid off and uti­liz­ing a 1031 exchange need to acquire a replace­ment prop­er­ty with a LTV equal to or greater than the loan being paid off. DST do have non-recourse loans. Bal­anc­ing the LTV is a skill that finan­cial advi­sors who deal in DSTs fre­quent­ly can assist the investors in the selec­tion process.

Exam­ples of Risk Approach­es

Eco­nom­ic cycles may alter the inter­pre­ta­tion of how con­ser­v­a­tive or aggres­sive invest­ments are con­sid­ered by investors. Low­er bor­row­ing rates may increase the avail­abil­i­ty of cred­its and the amount of debt an investor may secure.

• Very Con­ser­v­a­tive Approach:
  • LTV Ratio: 20%-40%
  • Ben­e­fits: Low­er risk, debt ser­vice low­er, high­er net income
  • Draw­backs: Addi­tion­al equi­ty required Less lever­age his­tor­i­cal­ly low­ers poten­tial returns
• Con­ser­v­a­tive Approach:
  • LTV Ratio: 40%-60%
  • Ben­e­fits: Mod­er­ate risk, increased debt ser­vice required, sta­ble cash flow
  • Draw­backs: Less equi­ty required and poten­tial low­er poten­tial return on equi­ty due to less lever­age
• Aggres­sive Approach:
  • LTV Ratio: 70%-80% or more
  • Ben­e­fits: High­er poten­tial return on equi­ty, sat­is­fy debt require­ments of 1031
  • Draw­backs: Less poten­tial cash flow, High­er risk, high­er debt ser­vice,

Con­clu­sion

The require­ments of the 1031 exchange may dri­ve the LTV need­ed. Bal­anc­ing the risk and returns, mar­ket con­di­tions, and investor goals are all part of the due dili­gence process. Investors who are enter­ing the mar­ket for the first time will eval­u­ate all the ele­ments of the invest­ment offer­ing. Pru­dent deci­sion mak­ing is need­ed for all invest­ments. The non-recourse aspect of DST may elim­i­nate the require­ments to apply for a loan and enjoy the debt assign­ment; all under­ly­ing aspects of the invest­ment need to be eval­u­at­ed.

DSTs are not for all investors. The acqui­si­tion of a DST is for accred­it­ed investors only. Con­tact your invest­ment advis­er for addi­tion­al details on how a DST may be a solu­tion to your 1031 Exchange and suit­ed for your invest­ment future. For more infor­ma­tion on how to prop­er­ly set up an IRC §1031Tax Deferred Exchange or if you are an accred­it­ed investor and would like addi­tion­al infor­ma­tion on a DST con­tact Al DiNi­co­la at 239–691-8098 or email adinicola@namcoa.com.

This is not an offer to pur­chase or solic­i­ta­tion to pur­chase any secu­ri­ty, as such be made only through an offer­ing mem­o­ran­dum or prospec­tus. Invest­ing in secu­ri­ties, real estate, or any invest­ment, whether pub­lic or pri­vate, involves risk, includ­ing but not lim­it­ed to the poten­tial of los­ing some or all of your invest­ment dol­lars when you invest in secu­ri­ties. You should review any planned finan­cial trans­ac­tions that may have tax or legal impli­ca­tions with your per­son­al tax or legal advi­sor. NAMCOA, LLC is a Reg­is­tered Invest­ment Advi­sor, reg­u­lat­ed by SEC (Secu­ri­ties and Exchange Com­mis­sion).

Our cor­po­rate office is locat­ed at 999 Van­der­bilt Beach Road, Suite 200, Naples Flori­da 34108. Secu­ri­ties Offered through MSC-BD, LLC, Mem­ber of FINRA/SIPC. 8215 SW Tualatin-Sher­wood Rd, Suite 200 Tualatin, OR 97062.  MSC-BD, LLC and NAMCOA are inde­pen­dent­ly owned and are not affil­i­at­ed.

Thank you.