A 1031 exchange is a tax-deferred transaction that can be used to postpone capital gains tax liability when selling and purchasing qualifying real estate. As you purchase a replacement property, there are plenty of options available to find the asset that suits your investment goals. One of these choices is the niche category of zero cash-flow properties. These are highly structured investments where you don’t earn any extra profit, but the income is paid to cover the property’s debt.
Zero cash-flow properties do not generate income for the investor, they may be used to address specific goals, such as debt replacement in a 1031 exchange. These structured investments carry both potential advantages and distinct risks. Keep reading to learn more.
What Are 1031 Zero Cash-Flow Properties?
A zero cash flow property is a commercial real estate asset that is structured so that the net income exactly matches the debt service on the property. In most cases, these assets are involved in long-term leases with tenants that have high creditworthiness, such as major shopping chains or large utility companies. The term will also usually include a fully amortizing, non-recourse loan.
Since the loan and the rental income are calibrated to cancel each other, you don’t receive any income on your end. In other words, there is no positive cash flow — hence the common term “zeroes.” However, you may not need to obtain additional financing since the rental payments cover it.
Those undergoing a 1031 exchange can choose a zero cash-flow property as the replacement asset. The structure of these deals often includes built-in leverage, which allows an investor to meet debt replacement requirements under IRS 1031 rules without needing to secure new financing. So, for those who want the potential tax deferral benefits without incurring additional debt, zero cash-flow properties are an option to evaluate. It’s unsurprising that this strategy is sometimes used for estate planning near the end of the exchange process, helping investors cover any remaining debt obligations.
Uses of Zero Cash-Flow Properties
Given the lack of positive cash flow, ending a 1031 exchange with a zero cash-flow property may seem counterintuitive. However, there may be certain structural benefits for specific investor profiles. Here are some advantages you can expect.
Debt Replacement Utility
Zero cash-flow properties are especially useful for meeting debt replacement requirements. Because they often come with fully amortizing, non-recourse loans, investors can assume like-kind debt without applying for new financing or a mortgage. This is particularly helpful for those who may struggle to qualify for new loans or prefer to avoid taking on additional liabilities. Zero cash-flow properties can help overcome those challenges.
Passive Investment
Zeroes often have long-term triple net (NNN) leases, an arrangement where the tenant pays for the property taxes, insurance premiums, and property maintenance costs. This structure helps ensure a predictable and stable income stream that precisely matches the equally predictable and stable debt service. As a result of the triple net lease, investors have minimal day-to-day responsibilities, which may appeal to those looking for low-involvement property ownership.
Tax Treatment
Even though zero cash-flow properties do not produce surplus income, they may offer tax-related benefits. For example, investors may be able to claim depreciation, which reflects a loss in value on paper even if the asset appreciates. These deductions can potentially offset other taxable income, depending on an investor’s situation.
There’s also the fact that you acquired the zero through a 1031 exchange. This transaction helps you defer capital gains tax payments until a triggering event occurs. Given how zeroes are often used for long-term estate planning, the asset may get a step-up in basis if you pass, providing additional relief to your heirs.
Risks of Zero Cash Flow Properties
While the benefits we shared make zero cash-flow investments appealing, some risks make this strategy unfit for certain investors.
No Cash Flow
As the name suggests, zeroes cannot provide any extra income. Everything will cover the debt. If you’re an investor who needs the extra funds or relies mainly on your real estate portfolio for retirement income, then this strategy won’t serve your needs.
Limited Liquidity and Exit Strategy
Most zeroes have NNN leases that are locked in 20-year or 30-year terms. As such, it may not be easy to access the asset in case you need cash. Many zeroes also include prepayment penalties or defeasance clauses, which can make selling or refinancing expensive and complex before the loan matures. This limited liquidity may restrict portfolio flexibility.
Risks With Tenants
While zero cash-flow properties are leased to creditworthy tenants, there’s no certainty that they won’t default. Once your tenant fails to pay rent, cash flow is interrupted, and you may need to find another resource to pay your debt obligations. In some cases, this could lead to foreclosure.
1031 Exchange Compliance Risk
In terms of the like-kind swap itself, you may encounter 1031 exchange property risks that stem from non-compliance with IRS rules. Failing to meet requirements—such as the 180-day timeline or the need for a qualified intermediary—can result in the loss of tax-deferral treatment. The loss of your tax benefits could lead to immediate tax liability.
Wrapping Up: Pros and Cons of Zero Cash-Flow Properties
Finishing a 1031 exchange with a zero cash flow property may be suitable for investors seeking passive investments, but still have unresolved debt. Because rental income is typically structured to match the mortgage payments, debt service may not require additional financing arrangements. However, since there is no positive cash flow from zero, investors must still take into account whether their portfolio has enough assets that can still provide income. As always, it is advisable to consult with your financial advisor or 1031 exchange experts to gain additional insight.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Article written by: Story Amplify. Story Amplify is a marketing agency that offers services such as copywriting across industries, including financial services, real estate investment services, and miscellaneous small businesses.
Sources:
https://www.investopedia.com/terms/t/triple-net-lease-nnn.asp
https://www.investopedia.com/financial-edge/0110/10-things-to-know-about-1031-exchanges.aspx
