Current market conditions only add to the potential benefits of Delaware Statutory Trusts in 2023
The realities of the current real estate market mean those looking to perform a 1031 exchange have had to adjust their strategies and be prepared for complications. But for some, the concern goes deeper: higher mortgage rates and difficulty in qualifying for a loan could affect both the person purchasing your relinquished property’s ability to complete the deal and your ability to secure your replacement property. How should you proceed when you can’t be sure what will happen to the market in the coming year?
How the current real estate market is affecting 1031
2022 was a chaotic year in the financial world, with runaway inflation and rising interest rates among the most widely-discussed issues. Mortgage rates nearly doubled, eclipsing 7% in the fourth quarter of 2022. Not only was it harder to qualify for a loan than it had been a year before, but even if you qualified, the terms would not be anywhere near as attractive.
Rates remain high in 2023, and while the expectation is that they will normalize as the year goes on, if you’re contemplating a 1031 exchange right now, you may not be able to wait for that to happen.
For example, what if you have a potential buyer for your relinquished property who wants to do a deal right now? If the offer is too good to pass up, you can’t wait for mortgage rates to go down – you need a replacement property soon. And what if your property is owned in connection with an operating business that’s no longer viable? You don’t want to have to keep that business operating at a loss until rates go down, and it may be difficult to find a short-term tenant given the current state of retail. Or what if you’re planning to move and can’t actively manage the property from out of state? Finding a trustworthy property manager to take on those responsibilities can be difficult.
In all those scenarios, it’s better to perform your 1031 exchange now, but current mortgage rates may make a traditional exchange less appealing or even impossible. For exchangers in certain situations, a Delaware Statutory Trust could be the answer.
The advantages of a DST
If you’re unfamiliar with how a DST works, you can read our full guide here. The most important thing for potential exchangers to understand is that it’s possible to perform a 1031 exchange into a Delaware Statutory Trust, which involves pooled funds used to purchase a property or group of properties overseen by a master tenant or professional property manager. The process for the exchange is largely the same, but unlike with actively-managed investment properties owned by an individual or partnership, with a DST:
- You don’t have to actively manage the property. Collecting rent, performing maintenance, and all other tasks are performed by the property manager.
- You get instant diversification: many DSTs involve more than one property, and you can exchange into multiple DSTs, meaning there is less chance of a boot from leftover equity resulting from your exchange.
- The average initial investment required is low compared to the cost of many individual properties, and because pooled funds are utilized, larger properties can be purchased, providing access to markets individual investors would have trouble accessing.
Most importantly, investing in a DST does not require you to qualify for a loan, which is what makes them beneficial during times like we currently face in 2023. In order to understand the issues mortgages present for exchangers and how a DST can solve them, it’s important to understand the principle of debt replacement in a 1031 exchange.
How a DST can help when mortgage rates are high
Section 1031 allows for deferral of capital gains taxes on the sale proceeds from a business or investment property when a like-kind property is purchased (and other conditions are met). If only a portion of the sale proceeds is used to purchase the replacement property, the remaining amount is subject to taxation. This amount is referred to as a “boot.”
To avoid a boot, your replacement property must be of equal or greater value to your relinquished property. But what if you have a mortgage on the relinquished property, meaning the sale proceeds will be less than the full value of the property?
The value of your replacement property still needs to be greater than or equal to the value of the relinquished property, regardless of whether you had a mortgage. This means that in order to avoid a boot, you need to replace the debt from the relinquished property, either with additional cash or with debt taken on in the purchase of the replacement property.
A simple example: if your relinquished property was valued at $1,000,000, your replacement property must be valued at $1,000,000 or more in order to avoid a boot. It does not matter if you had $0 of debt or $999,999 of debt at the time of sale. When purchasing the replacement property, the total of your cash invested plus debt taken on must meet or exceed the value of the relinquished property.
If you have a business or investment property with a mortgage, it’s normal to sell that property and acquire a replacement in a 1031 exchange by obtaining a mortgage for the replacement property. When mortgage rates are high as they are right now, it may be difficult to qualify for a loan, but that doesn’t mean you can’t take on the debt necessary to avoid a boot.
A DST is a pass-through entity, meaning all finances pass through to the investors. This not only means you receive dividends proportional to your investment from the income generated by the DST’s properties, but you also take on a proportional amount of the DST’s debt. When the DST is formed, it is determined whether or not it will take on debt to purchase its portfolio. If it takes on debt, that debt is passed on to investors at a loan-to-value ratio.
You can calculate how much debt each DST will require you to take on based on your amount invested. Then it’s a matter of selecting the right DSTs and investment amounts to cover both the cash proceeds from your relinquished property and the debt that needs to be replaced. If you cover both, you won’t have excess capital gains to be taxed.
What makes this beneficial when mortgage rates are high is that any loans are being taken out by the DST, not the individual investors. You take on the debt, but you don’t have to qualify for the loan. If you’re concerned about being unable to secure your replacement property because of difficulty in qualifying for a loan in the current market, exchanging into a DST (or multiple DSTs) can offer greater confidence that the transaction will be completed.
As for high interest rates affecting returns, that is a separate concern, as each individual DST focuses on different properties that require their own evaluation. But as explained above, you won’t have to worry about day-to-day property management and can benefit from the expertise of the property manager in maximizing the income from your investment as it appreciates in value. DSTs are also attractive in a volatile market because they can potentially negotiate better terms than you could as an individual. It depends on the particulars of the DST, but for a variety of reasons, it’s worth your time to investigate.
Using a DST as part of a 1031 Exchange
When exchanging into a Delaware Statutory Trust, the 1031 rules for property identification remain the same: you must identify your replacement properties before the 45-day deadline. Even if you have another replacement property in mind, a DST makes a great backup option to list as one of your identified replacements should your initial choice fall through.
The rules also remain the same regarding the use of a Qualified Intermediary. JTC has 30 years’ experience as a QI, with tens of thousands of successful transactions. Our clients benefit from our award-winning cloud-based platform and commitment to best practices in transaction security, transparency, and compliance, so you can complete your exchange successfully.
Learn more about JTC’s 1031 Services by downloading our 1031 Solution Sheet!