Bifurcated Exchanges into a 1031 Exchange and a Deferred Sales Trust with the possible use of a Delaware Statutory Trust for the 1031 Exchange Upside Replacement Property
The usual 1031 jargon is “up in value, up in loans”. In a bifurcated 1031 exchange you are doing 2 transactions- (1) a 1031 exchange and (2) a DST.
The 1031, in order to qualify as fully deferred, tax deferred exchange is treated by the IRS as though it is the ONLY transaction. The “Left Over” cash can be placed into the DST, if done properly.
Taxable Debt Relief. Debt relief occurs when a mortgage or loan is paid off at the sale of the old property. For the IRS, this is considered taxable unless 1) the exchanger can replace the old debt with an equal or larger new loan OR 2) the exchanger increases the amount of cash invested in the new property by the amount of debt relief. (usually with outside cash)
Really, the main requirement is that the upside property purchased has to be of a higher value than the property relinquished. It is not totally accurate to say that the loan amount on the upside has to be higher than the relinquished loan, because the delta in the purchase price could be made up in outside cash. However, practically speaking in most cases, is that you indeed obtain a higher loan, and in probably every scenario where you want to do a bifurcated exchange, you will always be taking on a higher loan. Doing so can leave excess cash from the sales proceeds to place into the DST. This is where high LTV Delaware Statutory Trusts seem to have the greatest value.
Usually, a bifurcated exchange into a 1031 transaction and a Deferred Sales Trust (often using a high LTV Delaware Statutory Trust as the exchange vehicle) is due to a loan over basis problem.
The following outlines the necessary steps in a 1031 exchange and the corresponding requirements:
Replacement Property Identification
The first step after selling an investment or business-related property and transferring the cash proceeds to an exchange accommodator is to mark your calendar for two key dates: the end of the replacement property identification period and the deadline for completing the purchase of a replacement property or properties. Starting on the closing date of your relinquished property, you have 45 days to identify potential replacement properties to be purchased with your sales proceeds. From the same close date of your relinquished property, you have 180 days to complete the acquisition of your replacement property or properties. For example, if you sold a property on January 15, 2018 then the second day of your identification period will be January 16, 2019.
Identification Deadline Purchase-Deadline
Days from the date of sale 45 days – 180 days
Three-Property Rule: You may identify up to three different properties as potential purchases within the 45-day identification period regardless of the total fair market value of the properties.
200% Rule: Alternatively, you can identify an unlimited number of replacement properties as long as the total fair market value of all properties does not exceed 200% of the value of all relinquished property in the same exchange. (e.g. sometimes you could be exchanging into multiple properties- beware double the headaches)
95% Rule: Another alternative is you may identify alternative properties as long as you receive at least 95% percent of the value of all identified replacement properties before the end of the exchange period.
You must meet the criteria of at least one of these rules for the identification of alternative replacement properties to be valid.
Replacement Property and Debt Requirements
When choosing replacement properties, you must keep a few rules in mind to ensure a proper exchange is completed.
The replacement property must be of equal or greater value, net of closing costs, than the relinquished property and all exchange equity must be reinvested ( Really meaning “no cash to you at close” ) for full tax-deferral. When purchasing multiple properties, the aggregate value of real estate must be equal or greater. Simply put, the two rules are “trade up” and “get no cash out.”
The debt on the new property or properties should also be equal or greater than the debt on the relinquished property, but fresh cash can be added to the transaction to offset a shortfall in replacement debt.
Boot: Under the rules of IRS code section 1031, only like-kind property held for investment or business purposes qualifies for a 1031 exchange. In some instances, there are items in an exchange that do not qualify for tax-deferral. Such items received are known as boot and can trigger a taxable event on the portion of the exchange that is not considered like-kind property.
Cash Boot: This occurs when the exchanger receives cash as part of the exchange. The exchanger doesn’t necessarily have to receive the cash proceeds in order for it to be taxable. For example, when a replacement property requires capital expenditure dollars to fund certain upgrades at the property that are made outside of the exchange, the capital expenditure dollars do not represent like-kind property and, therefore, could be cash boot; OR you receive an installment note for the balance as opposed to cash at the close of the upside.
The following is a list of example allowable and non-allowable expenses and closing costs in a 1031 exchange:
Allowable Expenses and Closing Costs:
- Real Estate Broker’s Commissions
- Qualified Intermediary fees
- Recording or Filing Fees
- Attorney Fees Related to the Acquisition
- Tax Advisor Fees Related to the Acquisition
- Owner’s Title Insurance Premiums
- Escrow or Settlement Agent Fees
- Finder Fees or Referral Fees-Documentary Transfer Taxes
Non-Allowable Expenses and Closing Costs:
- Financing Fees (loan fees, loan points, appraisal fees, mortgage insurance premiums, lender’s
- title insurance policy premiums, and other loan processing fees)
- Property Taxes
- Prorated Rents
- Repairs and/or Maintenance Costs
- Insurance Premium Payments
Mortgage Boot: When an exchanger reduces the mortgage liabilities on a replacement property below the relinquished property’s mortgage liabilities, mortgage boot is present. Therefore, the replacement property’s debt must be equal or greater than the sold property’s debt. In both cases of cash boot or mortgage boot, additional fresh cash can be added to offset these effects.
Sell property worth $1M with mortgage against = $500k
Upside must be purchased for at least $1M and have at least a $500k Mortgage
What if you only want to invest $250k out of your $500K in equity? Then the next property must be worth at least $1M and after your $250k down payment you will have to place a $750k mortgage on it. Normally the Accommodator would distribute the extra $250k in cash to you, which would constitute “cash boot” and you would pay tax on that.
However, what if you created a DST for that $250k that would otherwise be subject to tax? In that case, we have the Accommodator give you an installment note for the $250k instead of cash? Since you have not received the cash you do not have to recognize and pay cash on the boot. Then we have the Accommodator transfer the cash and assign the note to your DST Trust, who takes over the responsibility to pay you the $250K spread out in some form of periodic installments along with a rate of return (say 5% to 8%) on any unpaid principal.
You have now completed a bifurcated exchange, deferred all of your gains, diversified your investment holdings and created a separate income stream from any income you might generate from the upside exchange property.
(*) NOTE: For illustrative purposes, I have focused on the use of a Delaware Statutory Trust as the portion of the transaction represented by a 1031 exchange. The reason for that is that it is sometimes easier to get the correct mortgage debt level you are seeking. Using a Delaware as your 1031 replacement property is not the only option. You could also exchange into specified real properties that you will own and perhaps manage. As an example, you might be looking to exchange into property valued in excess of say $3,000,000 but you can only identify two properties with a total value of $2,500,000. In that case, the DST could complete your full tax deferral goals with the remaining $500,000.