Zero-Coupon 1031 Exchanges
By: Todd R. Pajonas, Esq., President
Matthew K. Scheriff, CPA, CES, Executive Vice President
James T. Walther, Esq., LLM, General Counsel
Legal 1031 Exchange Services, LLC
The need to obtain a high loan to value ratio can sometimes be problematic when purchasing a property to complete a 1031 exchange. Zero coupon properties, also known as zero cashflow properties, are a type of real property investment that affords investors the ability to acquire a property with a high loan to value assumable mortgage, or with certain types of zero-coupon properties, the ability to acquire the property for all cash and then refinance out proceeds utilizing a high loan to value ratio. Both types of zero-coupon properties are useful tools when used in conjunction with a 1031 exchange.
Zero-coupon properties are named as such because they use 100% of the rental income from the property to pay down the mortgage debt. This “hyper amortization” is what allows the lenders to provide such a high loan to value ratio, when considered in conjunction with the credit of the tenant, term of the lease, and quality of the underlying real property interest. In a traditional net leased investment, an investor would collect rent, pay their mortgage, and keep the net rental income, but the maximum loan to value ratio would be smaller.
In order to structure a fully tax deferred exchange, where an investor selling a property will not recognize any capital gains tax, the investor must purchase a replacement property or properties using all the net proceeds, plus they must replace the debt which was paid off on the sale property with new debt of equal or greater value when purchasing the new property (or inject an equal amount of cash from outside the transaction.) The replacement of debt can sometimes pose a problem where the net proceeds of the sale will not cover the tax obligations from the sale. This can happen because of a distressed sale, a short sale, a deed in lieu of foreclosure, or a foreclosure, which are all considered to be sales for purposes of Section 1031 of the Internal Revenue Code. This situation can also occur because the investor previously refinanced the property to a level where debt service exceeds current cash flow and they wish to sell to eliminate the negative cash flow, but the tax liability exceeds the net sales proceeds.
A potential solution to this problem can be to acquire a highly leveraged zero-coupon property which allows investors to satisfy their debt requirement to complete a 1031 exchange and effectively defer the taxes that would otherwise be due because of the sale.
An additional use of a zero-coupon investment is to obtain cash proceeds from the sale of a property without the resultant tax liability an investor would incur if a 1031 exchange were not employed. If an investor sells a property and does not utilize a 1031 exchange, or if they exchange for only a partial value, they will be taxed on the amount which is not reinvested. This taxable amount, which is subject to federal, state and local taxes, plus depreciation recapture, is known as “boot.” Instead of paying this tax liability to access the cash, investors can instead purchase a zero-coupon property using their 1031 cash proceeds, and then later refinance out the proceeds, which is generally not considered to be a taxable event. This “pay down / readvance feature” or “springing liquidity event” provides a pre-approved, pre-negotiated, means of accessing capital by utilizing a refinance. A zero-coupon property is purchased for all cash using a 1031 exchange, and after the purchase is complete, the investor utilizes the readvance feature to refinance the property. If a zero-coupon property were purchased for all cash in the amount of $6M the investor could potentially refinance proceeds of $5.1M at an 86% loan to value ratio.
Zero coupon properties exist because underwriters are more likely to approve financing for single-tenant net-lease properties that are occupied on a long-term basis by tenants with very strong credit. The capital markets view these mortgages as a hybrid of ‘corporate-financing’ with the addition of the loan being backed by real estate. This allows lenders to get more comfortable with higher loan-to-value ratios (“LTV”) and debt service-coverage ratios when compared to traditional norms. Lenders can instead focus on using all the cash flow from the property to service the debt, hence the name “zero coupon” or “zero cashflow” property. The amortization schedule for the mortgage is tied to the remaining length of the lease so that the principal balance is zero, or nearly zero, when the primary term of the lease expires. These mortgages are secured by the lease and the real estate and are normally non-recourse to the borrowers. Even in environments where it is challenging to find financing, it is sometimes possible to obtain mortgage financing of 85% on properties leased long-term (at least 20-years remaining on the lease) to tenants that have very strong credit.
As an alternative to highly leveraged traditional real estate investment in a triple net leased property, a Zero-Coupon Delaware Statutory Trust (“DST”) is a variation of the DST replacement property option for 1031 investors. DST investments are fractional interests in an investment trust that owns real estate, which qualifies as real estate for 1031 exchange purposes if the trust meets certain criteria specified in IRS guidance. Similar to triple net lease zero-coupon properties, zero-coupon DSTs also offer assumable non-recourse financing at a high loan to value ration which makes these investments easy to close within the 1031 exchange deadlines. DSTs are often used to help balance the debt and equity requirements of the exchange and are available in pre-set ratios like 50/50 LTV. The Zero-Coupon DST is a high LTV variation, but they allow investors to invest at much smaller amounts beginning at $50,000 in equity.
While the purpose of Zero-Coupon offerings may be to provide investors with a way to complete a 1031 exchange with minimal equity, there can be tax implications during the holding period of the zero-coupon interest. Generally speaking, all operating income is taxable unless it is offset by qualifying items such as interest payments on qualifying mortgages and depreciation. When the combination of interest payments and depreciation deductions is less than the operating income, the remaining income is typically taxable. However, since these zero-coupon structures use all of the operating income to service the mortgage payments, there is no cash flow available for distributions to the investors. This can lead to the creation of ‘phantom income’ where there is no cash flow to the investors, but the operating income is greater than the tax deductions, thus, creating taxable income. The timing and amount of phantom income is based on each investor’s individual circumstances, but it is likely to occur at some point during the holding period based on the amortization schedule.
In conclusion, it is important to think about a zero-coupon investment as a financial tool, rather than strictly a real property investment. The ability to acquire a property and assume a loan with a high loan to value, or to refinance out cash proceeds with a high loan to value, are the only benefits to these properties. These benefits must be weighed against phantom income and the inability to prepay the underlying financing without an extremely punitive prepayment penalty.
Legal 1031 Exchange Services, LLC does not provide tax or legal advice, nor can we make any representations or warranties regarding the tax consequences of your exchange transaction. Property owners must consult their tax and/or legal advisors for this information. Our role is limited to serving as qualified intermediary to facilitate your exchange.
Copyright © 2021 Legal1031. All rights reserved.