Can a DST's loan count as replacement debt in my 1031 exchange?

The trust borrows, but for tax purposes you are the one holding the mortgaged property

The chain runs through grantor-trust law rather than through anything in section 1031. Rev. Rul. 2004-86 holds that beneficial owners are grantors under §1.671-2(e)(3) and owners of an aliquot portion under §677, and that "because the owner of an undivided fractional interest of a trust is considered to own the trust assets attributable to that interest for federal income tax purposes," each owner is "considered to own an undivided fractional interest in Blackacre."

Owning a fractional interest in mortgaged real estate means owning it subject to your fraction of the mortgage. The trust's balance sheet is, to that extent, your balance sheet.

That is also why the interest is like-kind at all rather than a certificate of beneficial interest; do DST interests really qualify as like-kind works through the classification question on its own.

You are allocated the loan without an application, a guarantee or a credit file

The ruling's facts are explicit that the note "is nonrecourse to A" and that on contribution to the trust "neither DST nor any of its beneficial owners are personally liable to BK on the note." No lender underwrites you, and no lender can reach you.

For a retiring owner who has been told a new commercial loan needs a personal guarantee, tax returns and a debt-service-coverage test, this is usually the whole reason a DST is on the table. It replaces the borrowing, not just the property.

The trade is real, though. You inherit the trust's loan terms, its maturity and its refinancing exposure without any ability to renegotiate them; DST leverage and interest-rate risk sets out what that exposes you to.

At a loan-to-value ratio of L, a dollar of equity brings L ÷ (1 − L) of debt

This is the only formula you need, and it falls straight out of pro-rata ownership. If the trust holds a property worth V with debt D, the equity is V minus D, and your cash buys a slice of that equity; your share of the debt is your share of the trust, so the ratio of allocated debt to invested equity is simply D ÷ (V − D).

Written as a loan-to-value ratio, that is L ÷ (1 − L). The numbers below are what it produces, and they are worth memorising because the answer is not intuitive: a 50% LTV trust does not supply fifty cents of debt per dollar of equity, it supplies a full dollar.

1031 Crowdfunding puts the same relationship in dollars, describing a trust that buys a $10 million property with $5 million of debt, where an investor taking $50,000 of beneficial interest contributes "$25,000 in cash, while the remaining $25,000 is attributed to their share of the trust's debt."

• All-cash trust (0% LTV): $0.00 of debt per $1.00 of equity.
• 40% LTV: about $0.67 of debt per $1.00 of equity.
• 50% LTV: $1.00 of debt per $1.00 of equity.
• 60% LTV: $1.50 of debt per $1.00 of equity.
• 85% LTV: about $5.67 of debt per $1.00 of equity.
• 90% LTV: $9.00 of debt per $1.00 of equity.

The leverage you need is your payoff divided by your sale price, and nothing more complicated

Turn the formula around and the target falls out. If you must replace equity E and debt D, the trust leverage that lands you exactly on the number is L = D ÷ (D + E), which is your loan payoff divided by the net sale price you are replacing.

Take round hypothetical figures. A rental sells for $2,000,000, the closing retires an $800,000 mortgage, and $1,200,000 lands with your intermediary. Your target leverage is $800,000 ÷ $2,000,000, or 40%.

Put the whole $1,200,000 into a 40% LTV trust and you are allocated $1,200,000 × 0.667, which is $800,000 of debt, against $2,000,000 of replacement value. Equity, debt and value all land, and nothing is left over. The wider test is set out in the exchange equation guide.

Blend two trusts when no single offering sits at your ratio, and do not fear over-shooting

Offerings come at the leverage the sponsor chose, not the leverage you need, so the usual solution is a blend. Keep the same facts: $1,200,000 of equity and $800,000 of debt to replace, with only a 50% LTV trust and an all-cash trust available.

Send $800,000 to the 50% trust, which brings exactly $800,000 of allocated debt, and the remaining $400,000 to the all-cash trust. Total replacement value is $2,000,000 and total replacement debt is $800,000 — the same landing, assembled from two offerings.

Replacing more debt than you retired is not a problem and produces no boot. A shortfall does: the unreplaced relief is treated as money received under Treas. Reg. §1.1031(b)-1(c) and is taxed up to your realized gain. If you would rather close the gap in cash, replacing your mortgage or adding cash instead compares the two.

Free-and-clear sellers and highly leveraged sellers sit at opposite ends of the same dial

If you sold with no mortgage, your required leverage is zero and an all-cash trust replaces everything. Taking on trust debt anyway is a choice: it buys more property, and therefore more depreciable basis, in exchange for leverage you did not previously carry.

At the other end, an owner selling for $3,000,000 with a $2,700,000 payoff has $300,000 of equity and needs 90% leverage. Nine dollars of debt per dollar of equity is exactly what a zero-cash-flow structure is engineered to deliver; cash-out DSTs explained and the cash-out DST solution cover what that structure costs in cash flow.

Neither end is inherently right. Run the numbers on your own facts with your CPA or attorney, because the deferral is only worth having if the replacement is one you can live with for the trust's full life.

Where the allocated debt shows up on the return

Debt you shed and debt you take on meet on Form 8824. The instructions put on line 15 the "net liabilities assumed by the other party — the excess, if any, of liabilities (including mortgages) assumed by the other party" over the liabilities you assumed, the cash you paid and the non-like-kind property you gave up.

Your share of the trust's mortgage is one of the liabilities you assumed, so it reduces that line rather than appearing anywhere separately. Where the netting leaves a positive number, line 18 picks up the mirror image.

Subscribe to more than one trust and the instructions send you elsewhere: with more than one group of like-kind properties you skip lines 12 through 18 and "attach your own statement showing how you figured the realized and recognized gain." Reporting multiple properties or DSTs on Form 8824 shows what that statement contains.