A 1031 Exchange Strategy for Highly-Leveraged Property Owners With Significant Tax Liability
Many commercial property owners find themselves in a situation where their loans are coming due or they need to refinance because their property is not performing sufficiently to cover their existing debt. Unfortunately, they are frequently unable to secure replacement financing due to their very high leverage needs, particularly in today’s challenging lending environment. An example of this would be a property that was purchased for $2,000,000 with a loan of $1,000,000 which has lost $600,000 of its original market value. Now, instead of 50 percent loan to value (LTV), the taxpayer has over 70 percent LTV, a degree of leverage that is not likely available to them in the present lending environment. And the truly gut-wrenching dilemma for the taxpayer is that even if they can negotiate a sale, the resulting tax bill can be disastrous, often as a result of the depreciation that has been taken.
Delaware Statutory Trust
A 1031 exchange into a Delaware Statutory Trust represents a potential solution to the above dilemma that every real estate owner and advisor should consider when confronted with selling highly leveraged property. A Delaware Statutory Trust is a beneficial interest in a trust that holds real estate assets managed by professionals. These underlying assets are often single tenant net leased properties, or portfolios of net leased properties, with leases guaranteed by national credit tenants. Examples of the types of properties held by a Delaware Statutory Trust are necessity-based retail assets like drug stores; banks; grocery anchored shopping centers; single-tenant office and multi-family assets. These professionally managed trust interests can provide attractive returns and the benefits of real estate ownership, including depreciation pass-through.
Non-Recourse Financing
More significantly, certain Delaware Statutory Trust offer assumable, non-recourse financing, sometimes with leverage in excess of 80 percent. Delaware Statutory Trusts are most often thought of as income producing investments, but a very highly leveraged Delaware Statutory Trust can be used to reduce the investor’s debt level over time, while avoiding the out of pocket tax loss associated with a short sale or simply walking away from the property. The trust accomplishes this by directing all income to paying down the loan, thereby increasing the taxpayer’s equity over the course of the holding period. Then, upon the eventual disposition of the asset, the taxpayer can potentially use another 1031 Exchange to invest in an income producing Delaware Statutory Trust, in accordance with their enhanced equity position.
In the $2,000,000 property example above, the distressed property owner conveys the property for $1,400,000, pays off the $1,000,000 loan and uses a 1031 exchange with an 80 percent or more assumable non-recourse Delaware Statutory Trust for $1,400,000. The remaining 20 percent portion requires a cash infusion. The 25 percent recaptured depreciation tax is effectively deferred.
Delaware Statutory Trust Qualification
The 1031 Delaware Statutory Trust is not for everyone, given you must be an Accredited Investor as defined in Regulation D of the 1933 Securities Act and later defined by the 2010 Dodd-Frank Act. Individuals investors who have a minimum net worth of $1 million (excluding the value of a person’s primary residence), or have an annual income in the last two years of $200,000 if single or $300,000 if married, and have a reasonable expectation that this income level will continue in the future are candidates.
To learn more about this assumable non-recourse Delaware Statutory Trust, contact our office at 800.227.1031 or send an email with your questions to andgus@atlas1031.com.
This article is for informational purposes only and is not an offer to buy or sell nor an endorsement of any particular Delaware Statutory Trust offering. It is solely intended to illustrate how certain property ownership issues can potentially be resolved through the use of a 1031 exchange and a specific type of 1031-compliant replacement property.
