This article was posted on Wednesday, Apr 01, 2020

1031 Exchanges and Debt Replacement

The reason for selling and buying real estate via a 1031 exchange is to defer capital gains tax that would otherwise be due on the sale. By “exchanging” one or more pieces of property for one or more like-kind pieces of equal or greater value, and by adhering to IRS rules, the tax is deferred. One element of satisfying those rules concerns “debt replacement.”

In addition, it is worth remembering that since the 2017 Tax Cuts and Jobs Act 1031, exchanges are now generally limited to exchanges of real property. The “debt replacement” issue, therefore, excludes any debt associated with equipment, patents, etc. because the IRS now considers these boot.

What is Debt Replacement?

The term literally means what it says: the debt on currently-held property must be replaced in some way when acquiring the new property. It is important to understand that the IRS has no interest in, and offers no guidelines on, how an investor’s debt replacement is handled. All the IRS requires for the 1031 exchange to be valid is that the debt is not “cashed out” by acquiring property of less total value.

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How Does an Investor Achieve Debt Replacement?

To take a simple example, an investor exchanges real estate with a net value (sale price minus closing costs) of $2 million. The investor has a mortgage on the property of $750,000. That $750,000 will be paid off at closing and must be replaced as part of the acquisition. The acquired property, therefore, must be worth $2 million or more.

The investor has several options and may replace that $750,000 mortgage debt with:

  • Another mortgage of $750,000 (or more if the new property costs more than the net sales price.)
  • A smaller mortgage of, say, $500,000 plus a cash injection of at least $250,000 (to equal the original debt figure.)
  • A cash injection of $750,000, thus replacing the entire debt with cash.
  • A private loan.
  • Seller financing.
  • A combination of a new bank mortgage, cash injection, private loan, carryback note, etc. which together equal, or exceed, the size of the original debt.

The Takeaway
They key takeaway from the IRS perspective is that the original debt is replaced in full as part of the acquisition. How it is replaced is decided by the investor.

About Kay Properties and

Kay Properties is a national Delaware Statutory Trust (DST) investment firm. The platform provides access to the marketplace of DSTs from over 25 different sponsor companies, custom DSTs only available to Kay clients, independent advice on DST sponsor companies, full due diligence and vetting on each DST (typically 20-40 DSTs) and a DST secondary market. Kay Properties team members collectively have over 115 years of real estate experience, are licensed in all 50 states, and have participated in over 15 Billion of DST 1031 investments.

This material does not constitute an offer to sell nor a solicitation of an offer to buy any security. Such offers can be made only by the confidential Private Placement Memorandum (the “Memorandum”). Please read the entire Memorandum paying special attention to the risk section prior investing. IRC Section 1031, IRC Section 1033 and IRC Section 721 are complex tax codes therefore you should consult your tax or legal professional for details regarding your situation. There are material risks associated with investing in real estate securities including illiquidity, vacancies, general market conditions and competition, lack of operating history, interest rate risks, general risks of owning/operating commercial and multifamily properties, financing risks, potential adverse tax consequences, general economic risks, development risks and long hold periods. There is a risk of loss of the entire investment principal. Past performance is not a guarantee of future results. Potential cash flow, potential returns and potential appreciation are not guaranteed.

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