Debt replacement is easy to overlook and central to 1031 planning: your replacement property must carry at least as much debt as the one you sold, or the shortfall becomes taxable mortgage boot. A DST comes with its leverage already set, and it may or may not match what you need to replace.
The debt replacement rule
Sell a property with an $800,000 mortgage, move the proceeds into a DST, and you might assume your gain is fully deferred. If your DST allocation carries only $600,000 of debt, it isn't. The $200,000 shortfall becomes "mortgage boot" - debt you failed to replace, which is taxed as recognized gain. Part of the deferral you set out to capture quietly disappears.
The rule behind this sits at the center of every 1031 exchange: the debt on your replacement property must equal or exceed the debt on the property you sold. Come up short, and the gap is taxable.
It isn't optional, and it isn't something you can negotiate around. It's built into the structure of the exchange.
How DST leverage is allocated
A DST holds a single property with a single mortgage, and it splits that debt among its investors in proportion to what each one puts in. Own 2.5% of the equity and you carry 2.5% of the loan.
Your allocated debt = (your investment / total investor equity) x total DST financing
Run it with real numbers. Say a DST buys a $50 million property with a $30 million mortgage - 60% loan-to-value, meaning the loan covers 60% of the price - and raises the remaining $20 million from investors. A $500,000 investment is 2.5% of that equity, so your share of the mortgage is:
$500,000 / $20,000,000 x $30,000,000 = $750,000
For 1031 purposes, your replacement property is worth your equity plus your allocated debt: $500,000 + $750,000 = $1,250,000.
The capital stack at your level
The same deal looks like this when you lay out the capital stack - the layers of money used to buy the property, debt on the bottom and equity on top - at both the fund level and your slice of it:
Component | DST level | Your share (2.5% of equity) |
|---|---|---|
Property value | $50,000,000 | $1,250,000 |
Mortgage (60% LTV) | $30,000,000 | $750,000 |
Investor equity (40%) | $20,000,000 | $500,000 |
Your allocated property value |
| $1,250,000 |
Your allocated debt |
| $750,000 |
If the property you sold carried a mortgage of $750,000 or less, this allocation covers your requirement. If it carried $800,000, you're $50,000 short.
Your debt replacement number
Before you compare DST offerings, you need one number of your own: your debt replacement requirement. It's simply the outstanding mortgage balance on the property you're selling at the time of sale.
Selling more than one property? Add up every outstanding mortgage. Selling free and clear, with no mortgage at all? Your requirement is zero, and any debt a DST allocates to you is fine, because there's nothing you're required to replace.
Closing the gap when DST debt falls short
When a DST's allocation doesn't reach your requirement, you have a handful of ways to close it.
Raise the leverage. A DST at 65% LTV allocates more debt per dollar of equity than one at 50%. The same $500,000 investment stretches further:
DST LTV | Your investment | Your allocated debt |
|---|---|---|
50% | $500,000 | $500,000 |
55% | $500,000 | $611,000 |
60% | $500,000 | $750,000 |
65% | $500,000 | $929,000 |
Higher leverage covers a bigger requirement. It also raises your exposure if the property's value falls.
Invest more equity in the same DST. Because debt is allocated in proportion to your contribution, putting in more equity pulls more debt along with it.
Split across multiple DSTs. Spread your money across two or more funds with different leverage profiles. What matters is the total: your allocated debt across all of them has to meet or exceed your requirement.
Pair a DST with a direct purchase. Use a DST for part of the exchange and buy a property outright, with its own mortgage, for the rest. The combined debt across both counts.
Accept the boot. Proceed with the shortfall and pay tax on it. When the gap is small next to the total gain you're deferring, some investors treat this as the practical call rather than reshuffle the whole exchange.
Coordinating the moving parts
Debt matching only works if several parties are in sync, and it often breaks because each of them sees only part of the picture. Your CPA knows your requirement. The sponsor knows the DST's leverage. Your qualified intermediary - the independent party that holds your sale proceeds and processes the exchange so the money never lands in your hands - knows the structural rules. Nobody automatically checks that all three line up.
By around day 20 of your exchange, a well-run process has:
- Confirmed your total debt replacement requirement with your CPA
- Identified candidate DST offerings and calculated the debt allocation from each
- Verified with the DST sponsor that your allocated debt will be as calculated
- Confirmed with your qualified intermediary that the replacement property structure satisfies 1031 debt requirements
The common failure: an investor identifies a DST on day 40, closes by day 45, and finds out during tax preparation that the allocation is $50,000 short. Earlier coordination would have caught it.
Leverage as a risk factor
Debt matching is a tax question. The amount of leverage you take on is also an investment question, and the two don't always point the same way. Reaching for a high-leverage DST just to satisfy a debt replacement number sets aside a few things worth weighing:
- Debt service coverage. Does the property's income comfortably cover its mortgage payments? The debt service coverage ratio, or DSCR, measures exactly that - income divided by debt payments - and below 1.25x there's little margin for a bad stretch.
- Interest rate type. Fixed-rate debt is predictable. Variable-rate debt gets more expensive as rates rise, squeezing cash flow.
- Loan maturity. A DST can't refinance. If the loan comes due before the property is sold, the sponsor is boxed in.
- Downside exposure. At 65% LTV, a 20% decline in the property's value erodes most of the equity. At 50% LTV, the same decline still leaves a meaningful cushion.
Leverage that works on both fronts does two jobs at once: it meets the debt replacement rule and keeps risk within a range you're willing to hold for the life of the investment.
Questions to ask your advisor
- What is my total debt replacement requirement across every property I'm selling?
- What debt does each DST I'm considering allocate to me?
- Does that total meet or exceed my requirement?
- If it falls short, what is the most cost-effective way to close the gap?
- Is this DST's leverage appropriate for the property's risk, setting aside my debt replacement need?
- Has my QI confirmed that the replacement structure satisfies the 1031 debt requirements?
Coordinating your debt replacement requirement with your DST sponsor and advisors early, rather than discovering a mismatch around day 40, is what keeps an avoidable tax bill off the table.
Frequently asked questions
What is mortgage boot and why do I care about it?
Mortgage boot is debt you don't replace: when your replacement property carries less debt than the one you sold, the difference is treated as cash proceeds and taxed as gain. It matters because it works directly against the tax deferral a 1031 exchange is meant to give you.
How much debt do I need to replace?
At least as much as the mortgage on the property you sold. Sell with $500,000 of mortgage debt, and your replacement property needs at least $500,000 of allocated debt.
Can I put down extra cash instead of matching debt?
You can add cash, but it won't satisfy the debt requirement, because only debt counts toward debt replacement. Fall short on debt and the gap is taxable as boot, no matter how much cash you bring.
Do DSTs always have the right amount of financing?
No. DSTs are offered at a range of leverage levels, typically 50 to 65 percent LTV, so matching your requirement means finding one whose financing meets or exceeds it.
What if I need $400,000 of debt but the DST only has $300,000?
You have a few options: move to a DST with more leverage, spread across several DSTs, pair a DST with a directly owned property, or add cash and accept mortgage boot on the uncovered part.