The New Lender Wants More Down: Debt Replacement When Leverage Shrinks

A smaller loan creates net debt relief, and net debt relief is taxed like cash

Treas. Reg. section 1.1031(d)-2 treats the liabilities you are relieved of on the sale "as money received by the taxpayer upon the exchange." Reg. section 1.1031(b)-1(c) lets liabilities you take on in the exchange offset that amount, and the Form 8824 instructions add cash you pay and other property you give up to the offset.

On Form 8824 this shows up on line 15 as "net liabilities assumed by the other party": the excess of the debt taken over or paid off over any liabilities you assumed, cash you paid and other property you gave up. If that number is zero, debt is not your problem.

So if your old loan was $1,200,000 and the new lender will lend $1,000,000 on a property of the same price, $200,000 of debt relief is left unless you cover it. The lender's down payment rule becomes a tax problem.

The relief runs one way only. In the regulation's Example 2, an owner who took on $150,000 of debt while being relieved of $80,000 still recognized gain on the $40,000 of cash received. Can more debt offset cash taken out explains why.

Worked example: a 60% loan paid off, and a lender that will lend only 50%

Hypothetical, round numbers, ignoring closing costs. You sell for $2,000,000 and pay off a $1,200,000 loan, so $800,000 goes to the qualified intermediary. Your adjusted basis is $900,000, so the gain is $1,100,000. The new lender will lend 50% of value. Run your own numbers with your CPA.

• Option A, add cash: buy a $2,000,000 property with a $1,000,000 loan, $800,000 of exchange equity and $200,000 of your own cash. The cash offsets the $200,000 of debt not replaced, so nothing is taxed.
• Option B, buy less: buy a $1,600,000 property with $800,000 of equity and an $800,000 loan. Value and debt are both $400,000 short, so $400,000 of gain is recognized and $700,000 deferred.
• Option C, split with a high-leverage DST: put $680,000 of equity into a $1,360,000 property with a $680,000 loan, and $120,000, about 15%, into a DST interest whose share is $640,000 of property subject to $520,000 of trust debt. Total value $2,000,000 and debt $1,200,000, so nothing is taxed.
• Option D, add a second property or seller financing: a second purchase with its own lender, or a seller carry-back, adds debt without more equity; see seller financing on both sides of an exchange.

Option C works because the DST carries the debt you could not borrow

Our cash out DST is a high-leverage structure built on triple-net leased property with investment-grade tenants and long-term leases. All operating income services and amortizes the loan, investors receive no current distributions, and the payout comes on sale. The loan is non-recourse, so only invested capital is at risk.

Our de-levering case study describes a client at about 60% loan-to-value who placed about 15% of the exchange this way to satisfy the debt replacement and put the rest into debt-free property. The leverage in Option C above is illustrative only; each offering's documents set its own loan, and whether a DST's loan counts as replacement debt covers how the allocated share is documented.

The trade-offs are real. A highly leveraged DST pays nothing until sale, losses are magnified by leverage, interests are illiquid, and under Rev. Rul. 2004-86 the trustee of a DST like the one described may not renegotiate the debt, so a loan problem cannot be refinanced away.

Choose by what the extra equity costs you, not only by the tax

Adding cash is simplest but ties up money you may want elsewhere. Paying tax on a smaller purchase gives up deferral but lowers leverage for good, which deleveraging with a 1031 weighs in detail. Splitting with a DST keeps the main property at the lender's comfortable leverage while the DST holds the debt.

A lower loan-to-value offer can reflect a lender's debt-service coverage requirement when rates are high relative to rental income. Ask the lender early what the maximum loan is at your target price, so the gap is known before day 45.

If your old loan was large relative to the property's value, 1031 strategies for highly leveraged owners covers options beyond a single replacement.

The fix has to be on your identification list by day 45

Every option except adding cash needs property: a DST interest or a second building must be identified within the 45-day period under Reg. section 1.1031(k)-1(c), within the three-property or 200-percent limits. If you learn the lender's cap after day 45, only identified property or your own cash can fill the gap.

Get a written term sheet before you file your list, and identify the DST alongside the main property. If the term sheet improves later, you can simply not buy the DST; identifying a property does not oblige you to acquire it. The 60-day financing plan sets out when to ask.