Potential tax benefits are one reason you might invest in a Delaware Statutory Trust as a 1031 exchange replacement property. Other reasons might include portfolio diversification, access to quality real estate assets, and potential cash flow.
Then, there are zero coupon DSTs. These differ from your traditional DST but can provide advantages for debt, depreciation, and asset valuation.
Defining the Zero Coupon DST
The zero coupon DST is generally defined as a trust:
- That invests in triple-net-lease properties leased to high-credit tenants
- In which all cash flow goes to the lender to pay down the property debt
- In which you, the investor, don’t receive any distributions or income from the trust during the holding period
On the surface, it might seem counter-intuitive to funnel your money into an investment that doesn’t offer much payout. But there are certain times when the zero coupon DST can prove helpful.
When to Use
A zero coupon Delaware Statutory Trust investment can make sense under the following conditions.
Because cash distributions are directed toward the property’s mortgage, debt paydown can be much quicker. This faster paydown can improve the asset’s value, meaning a potentially higher total return when the property sells.
Maybe you refinanced a relinquished property recently. Or perhaps the relinquished property carries especially high leverage, making it difficult to find an ideal replacement property of greater or lesser value, resulting in lower overall equity. This can make it challenging to find the ideal replacement property of greater or equal value to the replacement property.
A zero coupon DST could provide the means to invest in a higher-leverage replacement property even if your relinquished property’s equity level is low.
Beware the Phantom
With its advantages, there are also zero-coupon DST risks. One involves operating income.
A property’s operating income is generally offset by property depreciation and interest payments on qualifying mortgages. As such, property leverage is typically high in the early going of a zero coupon DST, meaning it can offset property operating income.
But as the property’s debt is paid down, mortgage interest decreases, generating higher taxable income. This wouldn’t be a problem, except you’re not receiving that income – it’s going toward the debt.
But to the IRS, it’s all one and the same. You’re still responsible for paying your pro-rated share on that “phantom income,” even if you aren’t receiving the actual cash through distributions.
Considering Your Options
Using a 1031 exchange process to acquire fractional shares in a zero coupon Delaware Statutory Trust can generate investment benefits under certain scenarios. But before diving into this type of replacement property, understand the risks involved. Furthermore, seeking professional advice to help you determine your best path forward is always a good idea.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
No public market currently exists, and one may never exist. DST programs are speculative and suitable only for Accredited Investors who do not anticipate a need for liquidity or can afford to lose their entire investment.
Costs associated with a 1031 transaction may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.