Delaware Statutory Trusts (DSTs) are a popular option for investors seeking passive income, enhanced diversification, and access to institutional-grade assets. Among the many considerations to keep in mind before entering one is the financing structure. Amortized financing is the most common, but some DSTs also use a zero-coupon loan structure.
Zero-coupon DSTs delay payment of interest until the holding period is over. This structure provides certain advantages and challenges that investors must keep in mind. Below, Realized 1031 shares insights to help you understand the impact of these loans.
Understanding the Zero-Coupon Loan Structure
The zero-coupon loan is an arrangement wherein the borrower doesn’t immediately pay the principal and interest until the loan matures. For DST financing, this structure results in the following.
- For the entirety of the DST investment, the sponsor won’t have to pay interest on the loan.
- Instead, the interest accrues and is paid at the time of the property’s sale or refinancing.
- Since no payments are made, there’s more income for the DST to distribute to interest holders.
As such, DSTs with zero-coupon loans tend to attract investors who prioritize maximum passive income during the DST’s holding period.
Impact on Basis
Zero-coupon loans have an impact on the basis, which you must understand for future reinvestment and tax management. Keep in mind that your basis includes the capital you contributed plus your share in the DST’s debt, even when no payments are made yet. As interest grows over time, the loan balance also grows. This means that your share of debt also increases as the loan matures.
With the higher debt balance, you may face higher debt replacement values if you plan to enter another 1031 exchange after the DST’s holding period. This growing liability must be taken into account so you can prepare ahead of time and minimize debt replacement issues in the future. If you cannot replace that increased debt with an equal or greater amount of debt in a future exchange, the shortfall will be considered a taxable boot.
Cash Flow DST: How Zero-Coupon Loans Affect Earnings
The zero-coupon structure is beneficial for those who want to maximize passive income earnings. The structure delays debt service and interest payments until the end of the holding period, allowing more of the property’s income to reach the investors.
Keep in mind that delay doesn’t mean elimination. The DST will still need to pay the principal and accrued interest, which is usually taken from the proceeds of the property sale. In other words, investors are borrowing from future earnings to enjoy higher income today.
What About DST Exit?
The most significant impact of the zero-coupon loan comes during the exit, when the loan matures. As the DST sells the properties, the proceeds will be used to pay the principal and interest, which leads to lower net equity. As such, it’s important to set expectations to avoid being surprised by the lower profits you’ll receive.
Like we mentioned, investors exiting into another 1031 exchange must also replace not only the original debt but also the accrued interest that has inflated the payoff amount. You must prepare to replace this higher, inflated debt with an equal or greater amount of new debt in your replacement property.
In Summary: Zero-Coupon DSTs and Their Impact
Zero-coupon loans in DST investments present opportunities and challenges that impact the overall investment. While more income is preserved and distributed during the life of the DST, the delayed debt payments result in lower equity after the holding period. Understanding these effects can help you decide whether or not such a loan structure fits your needs.
Sources:
https://www.investopedia.com/terms/z/zero-coupon-mortgage.asp
https://www.investopedia.com/financial-edge/0110/10-things-to-know-about-1031-exchanges.aspx
