What is negative leverage in a 1031 exchange?

Hans Goldstein structures installment sales for sellers and works alongside their CPAs and brokers. Email hans@goldsteinco.net or call 213-414-2808.

How do you know if a loan is negative leverage?

Compare two numbers: what the property earns on its full price, and what the loan costs per year per dollar borrowed.

• Cap rate = net operating income (NOI) / price. This is the return if you paid all cash.
• Loan constant = annual debt service / loan amount. On an interest-only loan, the constant equals the interest rate. On an amortizing loan, it is higher, because each payment also repays principal.
• Cash flow = NOI minus annual debt service.
• Cash-on-cash return = cash flow / your equity.

If the loan constant is below the cap rate, the loan adds to your cash-on-cash return (positive leverage). If it is above, the loan subtracts from it (negative leverage). The interest rate alone can fool you: a 6.0% loan on a 6.4% cap looks positive, but on a 30-year amortization its constant is about 7.19%, which is above 6.4%.

The monthly payment on an amortizing loan uses the standard formula: payment = L x i / (1 minus (1 + i) to the power of minus n), where L is the loan, i is the monthly rate and n is the number of months (360 for 30 years). Multiply by 12 for annual debt service.

Why does a 1031 exchange push you into it?

Because of the debt side of the exchange. Loan payoff on the property you sell counts as money received unless it is offset. New debt on the replacement offsets it, and so does extra cash you add. Whatever is left over is boot, taxed up to your realized gain, under IRC §1031(b) and Treas. Reg. §1.1031(d)-2-2), Example 2. And taking on a bigger loan does not cancel cash you take out. The full netting rules are in the 1031 debt replacement rule.

The old loan almost never moves with you. Commercial notes carry due-on-sale clauses, so the loan is paid off at closing and the replacement needs a new one at today's rates, approved and funded inside the 180-day exchange window. So the debt amount is set by the old loan. Only its price is up to the market.

Worked example: a deal on my desk

Here is a rounded version of a deal on my desk: an office building selling for about $4.0M, with about $2.1M of debt taken out seven months before the sale. Assume the seller exchanges into a $4.0M replacement at a 6.4% cap rate, so NOI is $256,000, using about $1.9M of equity and a new $2.1M loan. The loan rates below are illustrative, not a quote for this deal. Closing costs are ignored to keep the arithmetic clean.

How the rows are built: interest-only debt service is $2.1M x rate (for example, $2.1M x 6.75% = $141,750). The amortizing payment at 6.75% is $13,620.56 a month, x 12 = $163,447 a year, and $163,447 / $2.1M = 7.78%. Cash flow at that row is $256,000 minus $163,447 = $92,553, and $92,553 / $1.9M = 4.87%.

The all-cash yield on the same building is 6.4%. Every row with a cash-on-cash return below 6.4% is negative leverage. Only the 6.0% interest-only row is positive. For a 30-year amortizing loan to break even against a 6.4% cap, the rate would need to be about 4.94%.

Two fair points on the other side. First, amortization is not a pure cost: at 6.75%, about $22,400 of the first year's payments repays principal, which builds equity rather than leaving the deal. Second, leverage cuts both ways on value: if the building appreciates, the gain on $4.0M of property accrues to $1.9M of equity. Negative leverage is a cash flow problem, not automatically a bad investment. But if you are exchanging for income, the cash flow is the point.

What does the market look like as of October 2026?

• Cap rates vs coupons on new loans. In loans securitized in 2026, CRED iQ reported on June 12, 2026 that "every 'favored' income sector is now borrowing through its cap rate": multifamily at a 5.45% cap vs a 5.64% coupon, industrial 6.03% vs 6.33%, self storage 5.70% vs 6.05%. Retail (6.81% vs 6.61%) and office (7.45% vs 6.50%) were still positive. CRED iQ also found 56% of that new-issue balance was full-term interest-only.
• Those coupons were set at lower Treasury yields. The 10-year Treasury was 5.24% on Oct 1, 2026 (FRED, DGS10), up from "near 4.6% as of mid-July" per the CBRE U.S. Cap Rate Survey H1 2026.
• Today's loan quotes. As of Oct 1, 2026, Northmarq's rates and spreads showed 10-year Freddie Mac loans at 6.30% to 6.45%, 10-year life company loans at 6.65% to 6.95%, and 10-year CMBS at 7.00% to 7.50%.
• Cap rates. MSCI's US Capital Trends (Feb. 2026) put trailing 12-month cap rates at 5.6% for apartments, 6.4% for industrial, 6.9% for retail, 7.3% for CBD office and 7.5% for suburban office.

Side by side, as of October 2026: an exchanger buying apartments or industrial with a new loan is likely borrowing above the cap rate.

How do exchangers deal with negative leverage?

There is no free answer. Each option trades something.

1. Put in more cash, take less debt. Cash you add offsets debt relief, so full deferral is still possible, but it takes cash you may not have. Or buy all cash and accept the boot: $1.9M of equity in a $1.9M building at 6.4% earns $121,600 a year, a full 6.4% with no debt, but the $2.1M of unreplaced debt relief is boot, taxable up to your gain. Use the 1031 boot calculator to see the tax on that.
2. Interest-only debt. The table shows it: interest-only narrows or closes the gap. The trade is no principal paydown and the full balance due at maturity.
3. A Delaware statutory trust with debt already in place. Your share of the trust's existing loan counts toward replacing debt, and you are not the borrower. You give up control and liquidity, and that debt was priced by someone else. See Delaware statutory trusts.
4. Exchange part, structure the rest. Exchange what fits at a debt level you are comfortable with, and handle the boot with a structured installment sale. See 1031 and installment sale together.
5. Pick a higher cap rate asset. Retail and office still borrowed below their cap rates in the CRED iQ data, usually with more vacancy or tenant risk.

Where does a structured installment sale fit?

For a seller who is done borrowing, a structured installment sale removes the forced new debt. The buyer pays in full at closing. Part of the price goes to an assignment company, which funds the payments to you with a fixed annuity from an insurer, and you report the gain under IRC §453 as payments arrive. You are not the lender.

What it does not do, stated plainly: the old $2.1M loan is still paid off at closing, prepayment penalty included, and that payoff is a year-one payment taxed at the sale's gross profit ratio. Depreciation recapture is taxed in the year of sale either way. What it removes is the new loan: no new rate, no negative leverage, no landlord job. The trade-offs: payments are locked once set and cannot be accelerated or cashed out, they depend on the assignment company and the insurer behind it, there is no published IRS ruling on this specific structure so your CPA should review it, a commission of about 4% of the amount structured is built into the pricing, and the interest in each payment is ordinary income. It has to be written into the purchase agreement before closing.

For brokers, this is a way to keep a deal moving when the seller stalls on the debt math. Run both paths with your own numbers in the advanced calculator, or send Hans the deal and he will lay them side by side for your CPA.

Frequently asked

Q: Is negative leverage the same as losing money? A: No. The property can still produce positive cash flow. Negative leverage means the loan lowers your cash-on-cash return below what the building would earn all cash. In the 6.75% amortizing example, cash flow is still $92,553 a year, but the return on equity falls from 6.4% to 4.87%.

Q: Should I compare the cap rate to the interest rate or the loan constant? A: The loan constant, if the loan amortizes. It is the full annual payment divided by the loan, so it includes principal. A 6.0% rate on a 30-year schedule has a constant of about 7.19%.

Q: Can I avoid new debt in a 1031 by adding cash? A: Yes. Cash you add to the replacement offsets debt relief, so you can replace $2.1M of payoff with $2.1M of cash or a mix. Taking on a bigger loan, however, does not offset cash you take out of the exchange.

Q: Does interest-only debt fix negative leverage? A: It helps, because the constant equals the rate. In the example, a 6.0% interest-only loan is positive against a 6.4% cap, while 6.75% and 7.25% interest-only are still negative.

Q: Does a Delaware statutory trust avoid negative leverage? A: Not by itself. The trust's loan is still a loan with a rate. It removes the work of getting a loan and being the borrower, but the cash flow still depends on how the trust's debt cost compares to its cap rate.

What should you read or run next?

• Advanced calculator
• 1031 boot calculator
• The 1031 debt replacement rule
• 1031 exchange with high interest rates in 2026
• 1031 vs structured installment sale when rates are high
• The problem with 1031 exchanges
• What is a structured installment sale?

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