Financed Replacement Property or All-Cash DST: The Debt Replacement Decision

The rule: a mortgage paid off at the sale counts as cash you received unless debt or new money replaces it

Section 1031(d) treats a liability another party assumes as money received in the exchange. Reg. section 1.1031(d)-2 supplies the netting rule in its second example: debt you are relieved of is offset by debt on the property you receive and by cash you pay, but cash you receive is not offset by debt you take on.

So the requirement is not to borrow again. It is to cover the debt you shed with one of two things: new debt on the replacement or money from outside the exchange. Replacing the mortgage or adding cash walks through the netting; this page compares the four practical ways to do it.

Value matters too. To defer fully you also need replacement property worth at least the sale price, which the exchange equation lays out line by line.

Four ways to cover the debt, from most control to least effort

Each route satisfies the same arithmetic. They differ in who owes the loan, who manages the property and whether you are paid along the way.

• Financed property you buy: a new mortgage at least equal to the old one. You choose the lender and the property, sign the loan, and must close inside the exchange period.
• Leveraged DST interests: the trust's loan is already in place, and your share counts as replacement debt; see whether a DST loan counts as replacement debt.
• Unlevered DST interests plus outside cash: you add savings or other funds equal to the debt paid off. No loan anywhere, but you need the cash.
• Split with a zero cash flow DST: a small portion of proceeds goes into a high-leverage trust that carries most of the required debt, and the rest goes into low-leverage or debt-free trusts.

Worked model: a $2,000,000 sale with an $800,000 payoff, covered four ways

Hypothetical round numbers, ignoring costs. You sell for $2,000,000, $800,000 pays off the mortgage, and $1,200,000 goes to the qualified intermediary. Full deferral needs $2,000,000 of replacement value and $800,000 of new debt or added cash. The loan-to-value figures below are illustrations, not terms of any offering. Run your own numbers with your CPA.

• Financed purchase: a $2,000,000 building with an $800,000 loan. Fully deferred.
• Leveraged DSTs at a hypothetical 50% loan-to-value: $1,200,000 of equity buys $2,400,000 of property carrying $1,200,000 of debt. Fully deferred, with more debt than needed.
• Unlevered DSTs with $1,200,000 only: $1,200,000 of value and no debt, so $800,000 of debt relief is unreplaced and taxable up to your gain. Adding $800,000 of outside cash to reach $2,000,000 fixes both shortfalls.
• Split: $200,000 into a zero cash flow DST at a hypothetical 80% loan-to-value buys $1,000,000 of property with $800,000 of debt; $1,000,000 into unlevered DSTs. Total value $2,000,000, total debt $800,000. Fully deferred.

Risk and income move in opposite directions across the four paths

Leverage magnifies outcomes both ways. A loan you sign may be recourse to you, depending on the lender. Breakwater's cash out DSTs use only non-recourse financing, so your personal assets are not pledged, but your invested equity takes the first loss if the property falls in value or the tenant stops paying. For any other trust, the private placement memorandum describes who is liable on the loan.

A zero cash flow DST pays no current distributions. Breakwater's description is that the properties are triple-net leased to investment-grade tenants on long-term leases, all operating income services and amortizes the loan, and investors are paid at disposition. That suits owners who do not need income from that slice and want the rest of their money in unlevered trusts.

Ask the sponsor how much taxable income the trust expects to allocate in years with no distributions, and read zero cash flow DSTs explained and DST leverage and interest rate risk before choosing a high-leverage trust. Unlevered DSTs carry no loan risk at the trust level but need the cash to cover your old mortgage.

Which fits: match the debt plan to your cash, your appetite for a loan and your need for income

Choose a financed property if you want control and are comfortable signing a loan inside 180 days; the 60-day financing plan covers the lender side. Choose leveraged DSTs if you want income and no loan signature. Choose unlevered DSTs plus cash if you have the outside money and want no debt anywhere.

Choose the zero cash flow split when you lack the outside cash, do not want to sign a loan, and want most of your equity unlevered. Owners deleveraging with a 1031 often use it for that reason. Breakwater's traditional DSTs and cash out DSTs can be combined in one identification list.

Whichever route you pick, put it on paper by day 45. A financed purchase can fall apart in underwriting, so many owners identify the property they want plus a leveraged DST that covers the same debt, staying inside the three-property rule or the 200% rule in Reg. section 1.1031(k)-1(c)(4). If the loan is not approved, the DST closes instead and the debt is still replaced. Leaving no backup means a failed loan turns your old mortgage into taxable boot.