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.
The zero coupon DST is generally defined as a trust:
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.
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.
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.
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.