Are there debt-free DSTs, and when should I use one?

All-cash trusts exist, and they follow the same tax rules as leveraged ones

A trust qualifies under Rev. Rul. 2004-86 because of what its trustee cannot do, not because of how the property was financed. The ruling's example uses a nonrecourse loan, but nothing in its analysis requires one. An all-cash trust is still a grantor trust, and your interest is still treated as an undivided fractional interest in real property.

Debt-free offerings are a smaller part of the market. EDGAR holds Form D notices for trusts sold under that label, such as a 2019 industrial offering with a $25,000 minimum. Whether a given trust carries debt is stated in its memorandum and shows in the use of proceeds; the DST leverage page explains how to read that.

If your old property had a mortgage, a debt-free trust leaves you short

Reg. section 1.1031(d)-2 treats debt you are relieved of as money received. Debt you take on in the replacement offsets it, and so does cash you add, but cash you receive is never offset by debt. A debt-free interest supplies no new debt, so the full mortgage payoff from your sale counts as boot unless you bring the difference in cash.

The usual fix is to split. Put part of the proceeds into a leveraged trust sized to carry the debt, and the rest into the all-cash trust. Matching your old mortgage with DST debt covers that arithmetic, and splitting between a DST and a direct property covers a mixed replacement.

Worked example: a $1 million sale with a $400,000 mortgage

Hypothetical round numbers; run your own numbers with your CPA. You sell for $1,000,000 net and pay off a $400,000 mortgage, leaving $600,000 with your intermediary. If all $600,000 goes into a debt-free trust, you have acquired $600,000 of property and no debt. That leaves $400,000 of net debt relief, taxable up to your realized gain.

Option one: add $400,000 of your own cash and buy $1,000,000 of debt-free interests, which offsets the relief entirely. Option two: put $300,000 into a trust financed at about 57%, which carries roughly $400,000 of debt on $700,000 of property, and $300,000 into the debt-free trust. Your total is about $1,000,000 of property and about $400,000 of debt, which matches what you gave up.

Option two keeps half your equity free of any lender while deferring all the gain.

Where an all-cash trust is the better fit

Sellers with no mortgage have no debt to replace, so leverage is a choice rather than a requirement. Without a loan, the trust carries no refinancing or maturity risk, a real constraint in leveraged trusts because the trustee cannot refinance; see what happens when a DST's loan matures.

Retirement accounts are the second fit. Under section 514, income from property bought with acquisition debt is partly taxable to an IRA, while rent from an all-cash trust stays excluded, as explained in buying a DST in an IRA or 401k.

Estate planning is the third. A filed DST trust agreement makes transfers of interests subject to the requirements of its loan documents; with no loan, that layer is gone. Your heirs still receive a basis equal to fair market value at death under section 1014 either way.

• Free-and-clear seller who wants no lender in the picture
• IRA or other exempt account buying with cash
• Owner planning to leave interests to heirs or a trust
• Investor who wants to avoid the risk of a loan maturing in a weak market

What you give up without leverage

Leverage magnifies results in both directions. An all-cash trust's returns are those of the property itself, with no loan to amplify a good year or deepen a bad one, and no lender reserves. Tenant, vacancy, market and sponsor risk are unchanged; a debt-free trust is not a guaranteed or insured investment.

There is also a basis effect. Under the basis rules in section 1031(d), illustrated in Reg. section 1.1031(d)-2, debt on the property you receive adds to its basis, so $600,000 of debt-free interests carries less depreciable basis than $1,000,000 of leveraged property bought with the same equity. Compare after-tax cash flow, not only headline distributions, with your CPA.