ALL LOAN TERMS ARE PREDETERMINED AND THERE ARE ONLY TWO PARTIES TO THE LOAN AGREEMENT: THE BANK AND THE TRUST ENTITY.
#7. Built-in, Off-Balance-Sheet, Non-Recourse Financing
Suppose a landlord converted her prior residence to a rental property 10 years ago (before retiring) after living in the home for five years. The original home mortgage now has 15 years remaining and the outstanding principal is approximately 50% of the home’s value. If she wants to conduct a complete §1031 exchange, she will need to replace the entire value of her rental property, including the loan. Like many retirees, her current income is lower than when she purchased the property as a residence.
Obtaining an investment loan, as opposed to an owner- occupied loan, may be an underwriting challenge. Taking on new debt also may limit her ability to qualify for other loans (e.g., to buy a vacation property or boat). In most DST programs 10 , the acquisition loan typically is in place before the first investors exchange into the property. All loan terms are predetermined, and there are only two parties to the loan agreement: the bank and the trust entity. Despite not being a named party to the loan, the individual DST investors each receive “credit” for their share of the nonrecourse loan for purposes of complying with §1031.
Here is a comparison of financing options for a §1031 investment under $5 million:
Typical Personal Investment Loan
Typical DST Financing
Investor is/has:
Yes
Loan qualification? Loan application?
No
No No No No No No No
Yes Yes Yes Yes Yes Yes Yes
Party to loan agreement? Personal recourse liability? Direct loan payments? Notarized closing documents? Public record of loan? Debt on their credit report?
Other typical terms of DST loans include:
• 10-year duration • Interest-only for 4 to 10 years • Prepayment penalty/yield maintenance
• Initial and ongoing reserve requirements • 45-60% LTV, with some sponsors offering “zero-coupon” programs at 75+% LTV
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