How to Approach Debt When Evaluating 1031 Exchange Options

A conversation we frequently have with clients when evaluating Delaware Statutory Trust (“DST”) 1031 exchange replacement property options is whether they should “assume” more debt than the debt currently on the property they are exchanging. The answer to this question depends on several factors, including the owner’s risk tolerance and personal views on debt. Undeniably, debt does have a certain amount of risk inherent to it, specifically the risk of either losing a property to a lender or a forced sale due to lack of adherence to the mortgage terms such as debt coverage ratios. On the flip side, there are multiple benefits to debt that can serve to enhance one’s investment which we discuss below.

First, debt is traditionally used to enhance an owner’s current cash flow and “leverage returns.” This concept is relatively straightforward and boils down to the fact that if the cost of capital (i.e. interest rate) associated with the debt is lower than the net operating income of the property as a percentage of the acquisition price (i.e. the “cap rate”), then the debt is contributory and there is a positive arbitrage by paying less for your borrowed money than your investment is earning. Additionally, should the property appreciate, all appreciation is attributed to the owner. Therefore, any amount of appreciation on a smaller amount of capital used to purchase the property translates to a greater overall percentage return on investment.

In addition to the first benefit of debt detailed above, it is worth noting that mortgage interest rates are nearly as low as they have ever been in the last 50 years. These rates are unlikely to stay this low into perpetuity. Locking in lower rates with fixed-rate debt could serve to pay dividends down the road.

The second significant benefit associated with debt is particularly impactful for owners that have either owned their property for 10+ years or have experienced significant appreciation and thus do not have much depreciable basis (see December 2017 article entitled “What is Basis and How Can I Calculated It”). As an owner’s depreciable basis declines, there is less available depreciation expense to offset the taxes associated with rental income. Exchanging into property with an increased loan-to-value compared to the relinquished property, enables an individual to acquire more depreciable basis without having to contribute additional equity. The depreciable basis will shelter income from taxes, one of the most favorable features of real estate as an asset class. Let’s look at the following example to illustrate this concept: