Replacing Debt in Your 1031 Exchange: Leveraging a Zero-Coupon DST

A 1031 exchange allows investors to defer the capital gains on the sale of their real estate by investing in a like-kind property. A like-kind property is defined as a “property held for productive use in a trade or business, such as income property, or [a] property held for investment … not only [does] rental or other income property qualified, so [does] unimproved property which has been held as an investment.”

To defer capital gains, however, an investor must purchase a replacement property that is of equal or greater value than the relinquished property sold; an investor could opt to purchase more than one property, but the same requirement applies. Therefore, if an investor sells a property for $1M, their replacement property or properties must have a combined value of $1M or more.

One of the biggest misconceptions in a 1031 exchange is that only the equity in the sale must be replaced; rather, both the equity and debt must be replaced. In the example used previously, let’s say the investor has $200,000 debt. In their exchange, they must invest their $800,000 equity, and replace their $200,000 debt – either by taking out another loan, or by pulling personal capital to invest.

Many investors completing a 1031 exchange are deterred due to this requirement – some may be avoidant of high interest rates, while others may be looking to remove debt and simplify their portfolios for estate planning purposes. Whatever the reason, it is important for investors to understand that there are alternative solutions for replacing such debt, and one that we would like to highlight is leveraging Delaware Statutory Trusts (DSTs) to replace that debt.

In this article, we will look at what a DST is, outline how investors can use DSTs to replace debt in their 1031 exchange, and why a zero coupon DST could be the best solution.

What is a Delaware Statutory Trust?

“A Delaware Statutory Trust, or DST, is a legally recognized real estate investment trust in which investors can purchase ownership interest. Investors who own fractional ownership are known as beneficiaries of the trust – they are considered passive investors.”

In 2004, the IRS approved DSTs as 1031-elligable investments. Therefore, those trading in their exchange can invest into a DST while deferring their capital gains.

“Properties held in DSTs that are considered “like-kind” include retail assets, multifamily properties, self-storage facilities, medical offices, and other types of commercial real estate.”

DST Structure: Replacing Debt in a 1031 Exchange

Similar to when investing in direct real estate, those going into a DST must also adhere to the replacement rules of a 1031 exchange. So, if an investor sells a property with $100,000 debt, they must still replace that in their investment in a DST. The major difference, however, is that when investing in a DST, an investor is assigned debt that is already on the real estate.

Let’s look at an example. Let’s assume an investor sells their real estate for $1M, and they want to invest in a DST. They have $700,000 equity after the sale and need to replace $300,000 in debt. They can invest in a DST that is 30% leveraged. As a result, they would be assigned that $300,000 debt when they invest, bringing their total purchase price to $1M.

The investor never has to take out a loan, but rather secures the financing previously obtained by the sponsor. Furthermore, the debt is non-recourse, and an investor has limited liability.

Leveraged DSTs: How Much Can You Leverage

Every DST offering is different, and it is up to the sponsor to identify how much an offering will be leveraged. Many offerings available are not leveraged – in this case, no debt is assumed. On the other hand, some offerings are available with over 50% loan-to-value, which can be a great option for an investor who is exchanging and is highly leveraged on their relinquished property.

Zero Coupon DSTs

There is a subset of DSTs called zero coupon DSTs – these are highly leveraged offerings that offer zero income to the investor. Rather, the cash flow goes directly to the lender to service the debt.

These offerings are suitable for both a full and partial exchange, depending on the investor’s goals. Here are the two most common uses for zero coupon DSTs.

Replacing Debt in a Highly Leveraged Transaction

When an investor is selling real estate that is highly leveraged, a zero coupon DST could be a suitable option to defer capital gains. Here’s an example.

Let’s say an investor sells their real estate for $2.5M, but they have $2M debt – they are 80% leveraged. This investor has two options – sell their real estate and pax taxes, including capital gains, or reinvest via a 1031 exchange.

After the sale, the investor will have $500,000 equity. If they opt to pay taxes, assuming a 40% tax hit, they will need to pay roughly $1M in taxes. As a result, they will need to pull an additional $500K capital to pay taxes.

The alternative option is to invest in a zero coupon DST. If they invest $500,000 into an 80% leveraged offering, their total purchase price will equal $2.5M. While they will not have any income on the offering, they will be able to defer their capital gains – in essence, they will be zero out of pocket.

The secondary perk to investing in a DST in this case is that they will benefit when the property sells – they will be able to complete another 1031 exchange. Depending on the offering, that leverage may come down during the hold period, if the deal is structured to pay down principal. Then, the investor can reinvest, possibly into a cash flowing deal in the future.

Leveraging a Zero Coupon in a Partial Exchange

Some investors don’t need to replace debt in a highly leveraged deal but may rather use the zero coupon DST as a strategic move to improve their purchasing position. For example, they may replace their debt in their exchange using a zero coupon DST, then use the rest of their equity to go into direct real estate, or another DST.

For example, let’s say an investor sells their real estate for $5M, but they have $1M debt. The investor has said that they want to go into direct real estate but are hesitant due to high interest rates. A zero coupon DST could be the optimal solution.

In this example, an investor could invest $250,000 into an 80% leveraged DST – this transaction would have a purchasing price of $1.250M ($250,000 equity plus $1M assigned debt). The investor would then be left with $3.75M to purchase real estate as an all cash buyer. They could either go into a lower or zero leveraged DST or purchase real estate direct. In some cases, by avoiding a high interest rate note, an investor can increase their cash flow through leveraging a zero coupon DST.

Zero Coupon DST: A Sample Investment

Capital Square, a national real estate firm specializing in tax-advantaged real estate investments, including Delaware statutory trusts for Section 1031 exchanges, acquired the Las Vegas Raiders training facility and corporate headquarters in Henderson, NV in 2022.

The facility was acquired on behalf of S1031 Zero Coupon LV Training Facility, DST, which seeks to raise $57.6 million in equity from accredited investors and has a minimum investment requirement of $50,000.

This investment will offer zero income for investors but will allow them to meet high debt requirement in their exchange. Louis Rogers, founder and chief executive officer of Capital Square, shared, ““This acquisition is a touchdown for Capital Square and our investors who need leverage to complete their Section 1031 exchanges.”

The facility represents what type of investment can be found in a zero coupon DST. In this case, the investment included a “336,000-square-foot built-to-suit facility features a three-story, 139,000-square-foot office building, 130,000-square-foot indoor practice facility complete with full and half-sized football fields, 50,000-square-foot performance center with a strength training gym, locker rooms and trainer/treatment areas, three outdoor football fields and an outdoor swimming pool.”

Completing a 1031 Exchange 

Every exchange is unique and reaching out to a 1031 professional can help investors better understand the options that are available in their exchange. The team at Perch Wealth can both outline the 1031 restrictions, but also highlight investments in both direct real estate and DSTs that may be suitable for an investors exchange.