At first glance, a zero cash flow investment might sound like a failure. After all, we invest with the hope of making money, right? Sure, but not every strategy follows the same path, and a zero cash flow investment may offer investors specific opportunities worth pursuing.
What Is a Zero Cash Flow Investment?
A “zero” is usually a long-term, triple-net leased commercial real estate property. Good examples of the type of property that are represented in zero cash flow investments include industrial centers, corporate office headquarters, and necessity-based retail power centers—typically backed by tenants with stellar credit ratings. The properties are often leveraged between 80 and 90 percent and structured so that all net operating income flows to the lender as part of the principal and interest payment. That is how the vehicle got the “zero cash flow” name. These investments are available for cash investors but are far more often sought out by those looking for high-debt replacement solutions (such as when needed for a 1031 exchange).
Why Is Debt Replacement Necessary?
When transacting a 1031 exchange, the investor seeks to defer the payment of both capital gains taxes and depreciation recapture. They can achieve this goal by directing the proceeds from selling the relinquished (subject) investment property into another purchase. Naturally, the 1031 exchange process has detailed requirements, including that the replacement property be considered (by the IRS) to be "like-kind" to the original and has a fair market value at least as high as the one it is replacing.
In addition to the total value of the properties selected to replace the property sold, the investor must finance the new assets with debt matching the amount held on the previous property, or the IRS will not allow the exchange.
Suppose that a taxpayer wants to sell an asset with an existing debt of $1 million and a gain of $1 million, and they prefer not to pay the taxes now. That investor needs to identify one or more replacement properties in which to invest the proceeds (the million-dollar gain) and match the previous debt obligation as well.
Zero Cash-flow DSTs May Offer a Strategic Alternative
Finding a high loan-to-value investment at the quality the investor seeks can be challenging, particularly if they prefer a non-recourse financing option. A zero cash-flow DST is a potential option for consideration. With any DST (Delaware Statutory Trust), it's vital to understand the sponsor's expertise and track record, and this fact is even more pronounced when you consider investing in a zero. Since the financing is a significant contributor to the potential success of the DST, an investor should investigate the sponsor and management carefully and consult a trusted advisor.
Zeroes May Appeal to Cash Investors as Well
While the zero cash-flow investment sparks interest in the ranks of investors seeking means to complete their 1031 exchanges, that is not the only potential participant group. Other investors may be motivated by their interest in owning commercial property without the need to contribute a significant starting investment. Others may be looking for potential tax benefits (tax advantages depend on many factors, including cost basis in the acquisition, so please consult your advisor).
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. 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. 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. 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. All real estate investments have the potential to lose value during the life of the investment. All financed real estate investments have the potential for foreclosure.
