Other creative uses for a DST
Even if you have a replacement property in mind, there are still ways to use a DST to solve certain 1031 issues.
1. If a 1031 investor finds a replacement property with a purchase price that is less than the sale price of their relinquished property, they can use a DST to make up the difference.
If you have cash left over from the sale it will be taxed as capital gains. Rather than pay the taxes, a DST can be used to make up the difference. In other words, 1031 investors who are open to investing in a DST won’t be limited to buying traditional real estate that is only of equal or greater value. This means more inventory/options to choose from, which can lead to greater investment success. This also means greater diversification which helps reduce investment risk.
2. If a 1031 investor has some “debt” that needs to be replaced, they can use a DST to satisfy this requirement.
The sale price of a 1031 investor’s property must be replaced in order to avoid having to pay any taxable boot. It is not technically the debt that needs to be replaced. If however, the 1031 investor does not have this cash available to add to the transaction (often the case), they will need to place financing on the replacement property that is equal to or greater than the existing debt from the relinquished property.
When doing a 1031, finding a suitable replacement property, getting it under contract, and then completing the inspections and financing within the short timeframe allotted by the IRS can be very challenging. Rather than having to worry about getting a new loan on the replacement property, a 1031 investor can use the debt that comes with a leveraged DST. This can save a huge amount of time during the exchange process.
For example, if a 1031 investor exchanges a $1,000,000 property with $200,000 of debt (the loan balance). This 1031 investor can buy $200,000 worth of that DST that is leveraged at say 50% and fully replace the debt from the relinquished sale ($200,000 of debt and a $400,000 total DST purchase price). As long as the 1031 investor is accredited, they automatically qualify for the DST loan and the debt is replaced. Additionally, the DST loan is non-recourse meaning the at the DST investor has no personal liability. This strategy also provides additional diversification for the 1031 investor.
3. If a 1031 investor is unable to find a suitable replacement property or is unable to complete their financing and due diligence prior to their 45-day identification deadline they can use the DST as a back-up identification.
Once again, finding a suitable replacement property within 45 days is a difficult task. Even if a 1031 investor is lucky enough to get an offer accepted within their 45-day deadline, it is almost impossible to then complete the financing and due diligence within that timeframe. Often, 1031 investors usually need several additional weeks beyond this date to complete the purchase. What many savvy 1031 investors will do is also identify a DST as a backup. The DST can then remain available for several weeks past the identification deadline. If financing falls through on the targeted replacement property, or something else comes up, a 1031 investor can fall back on the DST so they don’t get stuck having to pay capital gains.