I had a big mortgage payoff at closing. Can a zero cash flow DST replace that debt?

The payoff counts as cash you received unless you replace it

Reg. Section 1.1031(d)-2 treats the liabilities 'to which the property exchanged by the taxpayer is subject' as money received. A loan retired at closing is relief, and relief is boot unless offset by liabilities you assume or take property subject to, or by cash you pay; the regulation's second example confirms that cash paid offsets liability relief.

With a big payoff, adding cash is often not realistic, and a new personally guaranteed loan may be the thing you were trying to leave behind. Replace your mortgage or add cash sets out those two options; this page is about the third.

A highly leveraged trust replaces a lot of debt with very little equity

A Delaware statutory trust owner is treated as owning a fractional interest in the trust's property, per Rev. Rul. 2004-86, so your share of the trust's loan is debt you take the property subject to. At a loan-to-value ratio of L, a dollar of equity carries L ÷ (1 − L) of debt, as does a DST's loan count as replacement debt derives.

Our cash out DST page describes high-leverage trusts that solve debt requirements using only a small portion of proceeds, freeing the rest for low-leverage investments. Our cash out DSTs explained article puts that leverage often in the 80% to 90% range, which works out to $4 to $9 of debt per dollar invested.

The loans are non-recourse. No lender underwrites you, and only the capital you invest is at risk.

Worked example: a $2,000,000 payoff on a $3,000,000 sale

Hypothetical, round figures, costs ignored. You sell for $3,000,000, the closing pays off $2,000,000, and $1,000,000 reaches your intermediary. To defer everything you need $3,000,000 of replacement property and $2,000,000 of replacement debt or added cash.

Put all $1,000,000 into trusts at 50% leverage and you buy $2,000,000 of property with $1,000,000 of debt, leaving $1,000,000 of unreplaced relief taxed as boot up to your realized gain. Put $500,000 into a zero cash flow DST at 80% leverage instead and it carries $2,500,000 of property and $2,000,000 of debt; the other $500,000 goes into debt-free income trusts. The total is $3,000,000 of property and $2,000,000 of debt, and nothing is recognized.

At 90% leverage the same debt would need only about $222,000 in the zero, leaving more for income. Run your own numbers with your CPA.

• Zero cash flow DST: $500,000 equity, $2,500,000 property, $2,000,000 debt, no distributions.
• Debt-free income trusts: $500,000 equity and property, no debt.
• Total: $3,000,000 property, $2,000,000 debt, $1,000,000 equity, all gain deferred.

Size the zero to the debt, then the income trusts to your needs

Start with the debt you must replace and divide by the zero's debt-per-dollar figure to find the smallest subscription that covers it. Everything above that can go where income or diversification matters most, including traditional DSTs.

Over-replacing debt creates no boot, so rounding up the leveraged slice is harmless for tax purposes, though it adds risk. Several trusts mean a multi-property statement with Form 8824, covered in reporting several DSTs on Form 8824.

Check that each trust is on your identification list by day 45, and that the zero's minimum and closing timeline fit your 180 days.

What the leveraged slice costs you

Our pages are direct about it: all operating income goes to debt service and amortization, so the zero pays no current distributions, and value comes at sale. As the loan amortizes, the trust can produce taxable income with no cash, as the zero cash flow structure explained shows.

Leverage cuts both ways. A tenant failure or falling value hits a thin equity layer first, and on a foreclosure Reg. Section 1.1001-2 counts the full nonrecourse balance as money received, which can create gain without cash. Owners in this position may also want the guide for highly leveraged owners.