Must I exchange into property which is debt-free?

Question

I am selling my residential investment property. It is debt-free. I want to exchange into a management-free investment. If I buy property which is leveraged, will there be a consequence in  a future 1031 exchange?

For example:

I sell my current property for $3M. I buy a property for $3M +$1M of debt = $4M.

I later sell that property at the same price (to keep it simple) which is still $3M equity and $1M debt = $4M.

My NET sale would be $3M, so it makes sense to me that I would then 1031 exchange $3M into the next property. I would not be required to make a $4M purchase. Is thar correct?

Forgive me if the answer is obvious.

Jeff Klein · Answer

A more lengthy holding period doesn't concern me. In reading up about purchasing a property with leverage I see that there is also the advantage of more depreciation because I would be going into a larger property with more value.

So I'm looking for a balance of lower risk with the advantages of leverage. And to keep that risk down the leverage would be relatively limited. What would you consider a "relatively limited" LTV? 50? Less?

Dave Foster · Answer

@Jeff Klein,   You're thinking about it the right way.  The one caveat to remember is that the potential capital gain with financing can be a long ways down the road.  DSTs typically have more lengthy holding periods in part to accommodate the debt and need to gain equity for gain.  So you need to balance the flexibility of a shorter hold period as well and put that into the equation of your model, where you think the market is and if you anticipate jumping back in to fixed asset ownership.

Jeff Klein · Answer

Thanks, Dave. I would prefer a debt-free TIC or DST to, as you said, minimize the risk. But if I come across one that is attractive with some debt, what would you consider a low LTV ratio in the world of TIC's and DST's ? less than 50% ?  Lower?

The negative on no debt or low debt I guess is less potential for capital gain. So it's a trade-off between low risk and capital gain. Would you agree with my understanding?

Dave Foster · Answer

@Jeff Klein, Not quite.  You're selling your property for 3 mil but you are buying your passive investment   for $4 mil which consists of $3 mil in cash and $1 mil in debt - just like a regular mortgage.  When you later sell that investment if you sell for the same price you would be selling for $4 mil which means then that if you want to 1031 and defer all tax you would need to replace that with another asset worth at least $4 mil and use all $ 3 mil in cash in the purchase.

Once you leverage up you'll have to stay at least at that level in order to defer all tax.  Most of the investment types you're looking for do require some assumption of the debt of the project.  But if you're free and clear now and looking for cash flow I'd strongly consider that you forgo the risk of assumed debt and simply find and purchase a debt free TIC or DST.  They're out there.  Of course the vetting is the same.  But the simple fact that there is no debt alleviates a lot of the risk from the get go.