Investors that want to do a 1031 exchange using a property with high debt must ensure the replacement property also has at least the same level of debt. If the investor takes proceeds from the sale of the relinquished property and pays off its debt, the investor will realize a gain and will have to pay gains taxes. To avoid gains taxes, the investor can structure finances on the replacement property so that gains are not realized. A zero cash flow DST can help with this scenario.
A zero cash flow investment might sound like an odd or even undesirable investment. However, they definitely have a purpose. When used with DSTs, the zero cash flow structure is to acquire one property using a high amount of leverage, typically with a loan to value of roughly 70-90%, and pay for it with projected cash flows from the property. The net cash flow is basically zero. But the end result, with time, is the acquisition of another property. Triple-net leases in a DST, with long lease terms and hold periods of typically 15-25 years, are a common method for utilizing zero cash flow investments.
Zero cash flow DSTs utilize high credit clients. While no cash flow is guaranteed, high credit clients (rated by BBB- or above by S&P) are the most reliable lease clients available. These include clients such as Walgreens, Amazon, and similar large, well-established companies that can weather economic downturns. These investment-grade tenants allow the sponsoring company to get a much higher LTV for an asset than is typically given for non-investment grade tenants.
Example Of A Zero Cash Flow DST
Let’s look at an example of how a zero cash flow investment might work. An investor owns a highly leveraged property. It has a LTV (loan-to-value) of 70%. The investor sells the property, using the proceeds to pay off the loan. One problem is that this will generate a taxable event.
Instead, the investor can utilize a 1031 exchange to defer 100% of their taxes. But to remain compliant with IRS 1031 exchange rules, all sale proceeds must be spent on purchasing a property of equal or greater value to what they sold. In this case, it also means taking on an equal or larger loan. One way around this problem is to 1031 exchange into a DST.
At Realized, most of the DSTs we work with max out at about 55% LTV, which wouldn’t be enough for a client that just sold a 70% LTV property. This scenario is where zero cash flow DSTs come in. We can invest some of the investor’s proceeds in a highly leveraged (80%+ LTV) zero cash flow DST (DST #1) and the remainder in one or more traditional DSTs (DST #2). DST #2 will generate cash flow for the investor (but not DST #1).
Why not just 1031 exchange into a single high-levered DST rather than two? If the investor goes from a 70% LTV property into another 70% LTV property, they are right back where they started in regards to debt. One goal with this strategy is to reduce the investor’s LTV, which two DSTs can accomplish. Additionally, the investor gets some leverage out of the deal. They are able to utilize two DSTs, which means they are also diversifying across DST sponsors.
1031 Exchange With High-Levered DST
Below is an example of what 1031 exchanging into a high-levered DST looks like:
Relinquished property sale price - $1,000,000
Mortgage on relinquished property - $700,000
Net Proceeds from Sale - $300,000
The relinquished property sale price was $1 million, which means the replacement property must also be at least $1 million to tax-defer all proceeds. To meet 1031 exchange rules, the $300,000 in proceeds must be used to purchase the replacement property. Utilizing DSTs, the investor’s portfolio might look like the following:
- DST #1 — $85,715 invested into an 85% LTV zero cash flow DST, which would equal a total purchase of $571,433. That’s $85,715 of the $300,000 sale proceeds invested plus $485,718 (i.e., 85%) of allocated debt.
- DST #2 — The remaining $214,285 ($300,000 - $85,715) of sale proceeds are invested into a traditional 50% LTV DST that has projected cash flow, which would equal a total purchase of $428,570 ($214,285 from proceeds invested plus $214,285 of allocated debt).
The total purchase price for these two DSTs would be $1,000,003, which is more than the relinquished property's sales price. As you can see from the example, DST #1 is the highly leveraged DST, and #2 has potential cash flows.
Cash flows are never guaranteed, and any investment decision would do better not to put all of its weight into cash flows. Non-existent or poor cash flows can reduce the sale price of the property. This can negatively impact the investor’s equity position in the DST.
Under the right circumstances, as described above, a zero cash flow DST can certainly make sense when 1031 exchanging out of a high-levered property. An investor who is strictly looking for cash flow wouldn’t necessarily make use of this option. But if your main goal is to avoid gains taxes on a high-levered property, a zero cash flow DST strategy may be the right solution.
Example shown is hypothetical and for illustrative purposes only.
There is no guarantee that the investment objectives of any particular program will be achieved.
The actual amount and timing of distributions paid by programs is not guaranteed and may vary. There is no guarantee that investors will receive distributions or a return of their capital. These programs can give no assurance that it will be able to pay or maintain distributions, or that distributions will increase over time.
Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.
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