Challenges in Balancing the Equity and Debt in a §1031 Exchange ~ Part 1 Center Stage

On a week­ly basis, we receive calls from investors who are either con­tem­plat­ing doing Sec­tion 1031 exchange or in the mid­dle of doing a §1031 exchange. The com­po­nents of the exchange may rep­re­sent parts on the Jen­ga game.

April 16, 2025

By Al DiNi­co­la, AIF®
1031 Tax Deferred Exchange Spe­cial­ist & DST Advisor/Specialist
NAMCOA® — Naples Asset Man­age­ment Com­pa­ny®, LLC
Secu­ri­ties offered through MSC-BD, LLC, Mem­ber of FINRA/SIPC

Jen­ga is a block-bal­anc­ing game that requires a steady hand when remov­ing and replac­ing blocks to build a tow­er. The investor’s spe­cif­ic ques­tion is how do we bal­ance the cash equi­ty and replace the debt in the exchange. Investors who may be using a Delaware Statu­to­ry Trust (DST) may have a dis­tinct advan­tage. Espe­cial­ly if the investors want to main­tain and ful­fill the tax defer­ral require­ments of a §1031 exchange. Let’s take a look at how this would work out.

As a quick §1031 exchange refresh­er, remem­ber to ful­ly defer tax­es under Inter­nal Rev­enue Code Sec­tion 1031, you must rein­vest all the equi­ty or net equi­ty from the sale of the relin­quished prop­er­ty. You must also take on equal or greater debt unless you off­set that debt with new cash or fresh cash as it’s known. When you are exchang­ing with a DST, the investor may have a cou­ple of unique advan­tages, not seen in a tra­di­tion­al §1031 exchange. DSTs have been accept­able for over 20 years as replace­ment prop­er­ties for §1031. DST Exchanges are con­sid­ered pas­sive invest­ments. These pas­sive invest­ments are made up of investors who own a frac­tion­al share or ben­e­fi­cial inter­est in an insti­tu­tion­al qual­i­ty real estate offer­ing. The oth­er advan­tage that DSTs may have for exchang­ers is that it comes prepack­aged with an equi­ty com­po­nent as well as a debt com­po­nent (pro­vid­ing a loan to ratio). The chal­lenge is how do you choose the right DST to match your finan­cial sit­u­a­tion.

If you’re in an all-cash sit­u­a­tion on your 1031 exchange, you may invest in an all-cash DST replace­ment prop­er­ty or mul­ti­ple prop­er­ties. (There may be tax advan­tages for cer­tain all cash investors to acquire addi­tion­al debt for addi­tion­al tax effi­cien­cies). The option for all cash may be to diver­si­fy, either geo­graph­i­cal­ly or by asset class and poten­tial­ly pro­vide a more bal­anced replace­ment port­fo­lio. For exam­ple, if you sold $1,000,000 prop­er­ty and have all cash to invest, you may poten­tial­ly invest with four dif­fer­ent $250,000 prop­er­ties. (Addi­tion­al paper­work required). These acquired replace­ment prop­er­ties may be in dif­fer­ent states and there are maybe dif­fer­ent types (asset class­es) of real estate such as mul­ti­fam­i­ly, self-stor­age, etcetera. If you sold your prop­er­ty for a price of $1,000,000 and you paid off a $250,000 mort­gage, your net equi­ty is $750,000. For this exam­ple, we’re not wor­ry­ing about com­mis­sions and oth­er fees on clos­ing. The $250,000 mort­gage must be replaced with anoth­er mort­gage of $250,000 or the investor may be able to off­set that loan or new loan require­ment with addi­tion­al cash. That loan to val­ue (LTV) is a 25%. DST have by design non-recourse debt in the offer­ing. Over­all, the LTV may be as low as 15 or 20% or as high as 85% (by design) in recent years. Between a com­bi­na­tion of inter­est rates and more con­ser­v­a­tive under­writ­ing the loan to val­ue has gone down in finance deals. In addi­tion, the num­ber of all cash offer­ings in DST’s has increased. This increase in all cash offer­ings occa­sion­al­ly cre­ates a chal­lenge for §1031 exchang­ers who need debt replace­ment. You may be won­der­ing if there are DSTs with an exact match of the debt you require. This becomes a chal­lenge with bal­anc­ing the §1031 exchange. How­ev­er, we pro­gram our replace­ment matrix to enable us to pro­vide investors with a mul­ti­tude of alter­na­tives. Depend­ing on the investors’ desire for geo­graph­ic loca­tions or asset class­es the investor may say they only want to pur­chase self-stor­age or mul­ti­fam­i­ly prop­er­ties. Com­pound those require­ments with a com­bined total of 25% loan to val­ue. If we’re using the exam­ple from above. The $750,000 cash we may divide into two dif­fer­ent acqui­si­tions. One acqui­si­tion may be $300,000 and would be all cash. The investor has $450,000 of cash to invest but also needs to replace a loan in the amount of $250,000 (or greater). In this spe­cif­ic exam­ple if there was a DST with a 36% LTV the exchange would be valid. Mean­ing all com­po­nents sat­is­fied.  All the cash would be used ($300,000 + $450,000) and with an LTV of 36% there would be a replace­ment loan of $250,000.  The total replace­ment val­ue would be $1,000,000.

The biggest advan­tage the DST’s may have been that the investors do not need to apply for or be approved for the loan or debt assign­ment on the replace­ment prop­er­ties. This becomes incred­i­bly impor­tant because of the strict time peri­ods has for iden­ti­fy­ing and com­plet­ing the exchange. The biggest imped­i­ment may be iden­ti­fy­ing the prop­er­ties with­in a peri­od of 45 days. In a tra­di­tion­al exchange, apply­ing for and get­ting approved for a loan for replace­ment prop­er­ty in a tra­di­tion­al real estate with­in the 45-day iden­ti­fi­ca­tion peri­od may be the main rea­son exchanges fail. Cou­ple that with oth­er con­tin­gen­cies to be released cre­ates even more needs for bal­anc­ing and may be next to impos­si­ble or at least cre­ate a lot of stress and chal­lenges for the investor. We have been able to assist investors to match their replace­ment require­ments with funds to replace and debt assign­ments near­ly down to the pen­ny.

There are pit­falls to avoid though. If you don’t rein­vest all the pro­ceeds or replace the debt, you’ll be taxed on the dif­fer­ence. This dif­fer­ence is called boot. The oth­er prob­lem exists with the tra­di­tion­al exchange, maybe the abil­i­ty to get the debt replace­ment as men­tioned in a spe­cif­ic peri­od of time or under­es­ti­mat­ing the amount of debt that needs to be replaced. Even a small amount of debt short­fall could cre­ate a tax lia­bil­i­ty for the investor. One thing to under­stand with the DSTs is that they have fixed debt lever­age. In oth­er words, if the debt ser­vice is an inter­est only loan or ful­ly amor­tized loan (P & I pay­ments) over the course of the peri­od of time the loan terms can­not be changed.

In Part Two (Chal­lenges in Bal­anc­ing the Equi­ty and Debt in a §1031 Exchange ~ Part 2 Back  Stage), we will look behind the strate­gies and pro­vide insight into the bal­anc­ing matrix on the DST acqui­si­tion process. This may be inter­est­ing for larg­er exchanges that can acquire a large port­fo­lio of prop­er­ties pro­vid­ing diver­si­fi­ca­tion.

NAMCOA® is a SEC reg­is­tered invest­ment advi­so­ry firm that pro­vides com­pre­hen­sive port­fo­lio man­age­ment, finan­cial plan­ning, and fidu­cia­ry deci­sion-mak­ing ser­vices on behalf of retire­ment plan spon­sors. Our Dif­fer­ence is sum­ma­rized by our fidu­cia­ry approach which enables us to bet­ter meet port­fo­lio and retire­ment plan objec­tives, result­ing in stronger risk adjust­ed returns for investors and peace of mind for Clients. We also focus on alter­na­tive real estate invest­ment. Many real estate investors are seek­ing tax deferred solu­tions uti­liz­ing §1031 exchanges or Oppor­tu­ni­ty Zones.

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 §1031 Tax 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. 5 Cen­ter­pointe Dri­ve, Ste. 400 Lake Oswego, OR, 97035. MSC-BD, LLC and NAMCOA are inde­pen­dent­ly owned and are not affil­i­at­ed.

Thank you.