The Role Of Debt Financing In 721 Exchange Properties: Pros And Cons
An Internal Revenue Code Section 721 exchange is a type of transaction where a partnership or other entity can contribute appreciated property to a real estate investment trust (REIT) in exchange for operating partnership units (think REIT shares) of the REIT without triggering a taxable event. Debt financing can be used in conjunction with a 721 exchange to finance the acquisition of the replacement assets.
Here are some potential advantages and disadvantages of using debt financing in a 721 exchange:
Advantages Of Using Debt Financing In A 721 Exchange UPREIT
Increased purchasing power
By using debt financing, the partnership or entity can increase its purchasing power and acquire properties that they might not be able to afford with all-cash financing. This can allow them to take advantage of investment opportunities and portfolios that might not otherwise be available.
Debt financing can potentially increase the returns on the contributed properties if the properties generate a higher rate of return than the interest rate on the debt (as of the time of this publication, debt is still dilutive, not accretive).
The interest paid on the debt can be deducted from the partnership or entity’s taxable income, reducing their overall tax liability.
If your basis is zero, you get to depreciate the additional debt.
Reduced equity requirements
By using debt financing, the partnership or entity can reduce the amount of equity required to acquire the replacement properties, which can free up capital for other investments or uses.
Debt financing can enable the partnership or entity to diversify their real estate holdings by acquiring a mix of properties or portfolio with different characteristics and income streams.
Disadvantages Of Using Debt Financing In A 721 Exchange
Here are some potential disadvantages or risks of using debt financing in a 721 exchange:
Increased risk of default
By taking on debt to finance the acquisition of contributed properties, the partnership or entity is taking on additional financial risk. If the properties do not generate sufficient income to cover the debt payments, the partnership or entity may be unable to meet their financial obligations and could default on the debt.
Interest rate risk
Debt financing exposes the partnership or entity to the risk of rising interest rates. If interest rates increase, the cost of servicing the debt will increase, potentially reducing the overall profitability of the investment.
Higher costs and fees
Debt financing can come with higher costs and fees compared to all-cash financing, including origination fees, appraisal fees, and other closing costs.
Reduced cash flow
Debt payments can reduce the cash flow generated by the contributed properties, which can limit the partnership or entity’s ability to reinvest in the properties or make distributions to investors.
Debt financing can limit the partnership or entity’s flexibility in managing the contributed properties, as they must generate sufficient income to cover the debt payments and meet other financial obligations.
It’s worth noting that debt financing also comes with potential risks and downsides, such as the risk of default, the risk of rising interest rates, and the potential for higher costs and fees associated with the financing. As with any investment decision, it’s important to carefully consider the pros and cons of debt financing in a 721 exchange and consult with a qualified financial advisor or tax professional before making any investment decisions.
If you’re entering a 1031 exchange and have debt to replace, it’s important that your Delaware Statutory Trust property carries non-recourse debt or that you cover your debt replacement in some other way. Otherwise, you will be paying capital gains tax on that debt boot.
Fortunately, there are a number of ways to cover your debt requirement so that when you exit your 1031 property with debt, you’re able to purchase a 721 DST and satisfy your debt requirement before transitioning to the REIT. For example, one 721 DST Sponsor will lend up to your equity contribution. That’s just one method. There are a handful of other ways.
Thinking of doing a 1031 Exchange, DST, or 721 Exchange? Sera Capital helps clients by acting as a fee-only fiduciary focusing on tax-efficient exit planning. We offer DST 1031 exchange services through special situations where investors could put 1031 real estate into a securitized property while deferring taxes.