A 1031 exchange is a widely used and effective tax-deferral strategy available to real estate investors. By reinvesting proceeds from the sale of an investment property into a like-kind replacement property, investors can defer capital gains taxes indefinitely. However, the IRS imposes strict rules to ensure compliance—one of which is the 200% Rule.
Many investors are unaware that debt must be included when calculating replacement property values under this rule. This oversight becomes especially critical when considering Delaware Statutory Trusts (DSTs), as many are leveraged deals.
In this guide, we’ll break down:
- What the 200% Rule is and how it works
- Why debt assumption is a key factor in compliance
- How the rule applies to DST investments
- Common mistakes and how to avoid them
By the end, you’ll have a clear understanding of how to structure your 1031 exchange while staying within IRS guidelines.
What Is the 200% Rule in a 1031 Exchange?
The 200% Rule is one of the three property identification rules the IRS allows for 1031 exchanges. Investors must adhere to one of these when selecting replacement properties:
- The Three-Property Rule – Identify up to three properties of any value.
- The 200% Rule – Identify more than three properties, but their combined fair market value must not exceed 200% of the relinquished property’s sale price.
- The 95% Rule – Identify any number of properties, but you must acquire 95% of their total value.
Most investors use either the Three-Property Rule or the 200% Rule because the 95% Rule is difficult to satisfy.
Why the 200% Rule Matters
The 200% Rule is a key guideline in a 1031 exchange. It allows you to identify multiple replacement properties—as long as their combined fair market value doesn’t exceed 200% of your relinquished property’s sale price.
Example:
- Relinquished Property Sale Price: $500,000
- 200% Limit: $500,000 × 2 = $1,000,000
You can identify more than one property, as long as their total value doesn’t go over $1 million:
- Property A: $400,000
- Property B: $300,000
- Property C: $300,000
- Total: $1,000,000 (right at the 200% limit)
If your identified properties exceed this limit and you don’t meet an exception (like the 95% rule), your 1031 exchange could be disqualified—triggering capital gains taxes on the full or partial amount.
Why Debt Must Be Included in the 200% Calculation
A common mistake investors make is ignoring debt when calculating the total value of replacement properties. The IRS requires that both equity and debt be included in the 200% calculation—especially important when investing in leveraged DSTs.
How Debt Affects the Calculation
When investing in Delaware Statutory Trusts (DSTs), it’s essential to account for leverage—many DSTs carry mortgages. If a DST has a 50% loan-to-value (LTV) ratio, only half of the property’s value comes from investor equity. But when applying the 200% Rule, the IRS considers the full value of the property, including any debt.
Example Scenario:
- Relinquished Property Sale Price: $500,000 (no debt)
- 200% Limit: $1,000,000
Identified Replacement Properties:
- DST 1: $300,000 (unleveraged, no debt)
- DST 2: $400,000 total value (50% LTV → $200,000 equity + $200,000 debt)
- DST 3: $500,000 total value (60% LTV → $200,000 equity + $300,000 debt)
At first glance, the equity invested appears modest:
- $300,000 (DST 1)
- $200,000 (DST 2)
- $200,000 (DST 3)
- Total Equity: $700,000 — well under the $1 million limit
However, the IRS counts the full property values:
- $300,000 + $400,000 + $500,000 = $1,200,000
That’s over the 200% limit, which could disqualify the exchange unless you meet another exception (like the 95% rule). So, even if your cash investment is within limits, the total value of properties identified is what really matters.
Consequences of Exceeding the 200% Rule
- Disqualified exchange: Capital gains taxes apply.
- Partial exchange treatment: Only some proceeds are tax-deferred.
To avoid this, investors must account for both equity and debt when selecting replacement properties.
How the 200% Rule Applies to DST Investments
Why DSTs Are Popular in 1031 Exchanges
- Passive ownership – No landlord responsibilities.
- Diversification – Invest in multiple properties through a single DST.
- Institutional-quality assets – Access to large commercial properties.
However, many DSTs are leveraged, meaning they include debt. Investors must ensure their total identified value (including debt) stays within the 200% limit.
Example: Leveraged DSTs and the 200% Rule
Let’s say you sold a property for $1,000,000. Under the 200% Rule, you can identify replacement properties with a combined fair market value up to $2,000,000.
Identified DSTs:
- DST X: $1,000,000 (unleveraged, no debt)
- DST Y: $1,600,000 total value
- $800,000 equity + $800,000 debt
Combined Value:
$1,000,000 (DST X) + $1,600,000 (DST Y) = $2,600,000
🚫 This exceeds the 200% limit!
How to Fix It:
To stay compliant, you’ll need to either:
- Reduce the number of DSTs identified, or
- Choose DSTs with lower leverage or no debt at all
Even if your equity investment fits within the limit, the IRS counts the entire value—debt and all.
Common Mistakes & How to Avoid Them
- Ignoring Debt in Calculations
- Always include both equity and debt when assessing replacement properties.
- Misunderstanding the Three-Property Rule vs. 200% Rule
- If identifying more than three properties, the 200% Rule applies.
- Failing to Consult a Qualified Intermediary (QI) or Tax Advisor
- A 1031 exchange specialist can help structure the transaction correctly.
Conclusion & Next Steps
The 200% Rule is a crucial component of a successful 1031 exchange, especially when investing in leveraged DSTs. By accounting for both equity and debt, investors can avoid costly mistakes and maintain tax deferral.
An Elevated View
Here at Perch Wealth, we specialize in 1031 exchange replacement properties and Delaware Statutory Trusts (DSTs). Contact us today to learn more about how this tax deferral strategy may help with your portfolio diversification and long-term financial planning.
FAQs: 200% Rule for 1031 Exchanges
1. What happens if I exceed the 200% Rule in a 1031 exchange?
Exceeding the 200% limit risks disqualifying your exchange, triggering capital gains taxes on the overage. The IRS may treat it as a partial exchange, taxing proceeds not reinvested within the rules.
2. Do I include debt when calculating the 200% Rule?
Yes! When applying the 200% Rule, the IRS requires you to include the full fair market value of each identified replacement property—including both equity and any associated debt.
For example, if you invest $500,000 in a DST with 50% leverage, the IRS counts the entire $1 million property value toward your 200% limit.
3. Why are DSTs tricky for the 200% Rule?
Many DSTs are leveraged, meaning they include mortgage debt. If a DST has a 60% loan-to-value (LTV) ratio, a $400,000 equity investment comes with $600,000 in debt—making the total property value $1 million.
This full amount counts toward the 200% Rule, so if you’re not careful, leveraged DSTs can quickly push you over the limit.
4. How can I ensure my 1031 exchange complies with the 200% Rule?
- Work with a qualified intermediary (QI) and tax advisor.
- Calculate total replacement property values (equity + debt).
- Stick with unleveraged DSTs or limit identified properties to stay under 200%.
