Zero-Coupon 1031 Exchanges
By: Matthew K. Scheriff, CPA, CES
Executive Vice President – Legal 1031 Exchange Services, LLC
As investment real estate values have deteriorated and financing for properties remains very difficult to obtain, more and more investors find themselves in a predicament where they want or need to sell a property, but the net proceeds of the sale will not cover their 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 also considered to be sales for purposes of Section 1031 of the Internal Revenue Code. This can also happen because the investor previously refinanced the property to a level where debt service exceeds current cash flow and they want to sell to eliminate the negative cash flow, but the net sales proceeds are less than the tax liability.
A potential solution to this problem may be the use of highly-leveraged (or ‘zero-coupon’) properties to allow investors to complete a 1031 exchange and, therefore, defer the taxes that would otherwise be due as a result of the sale.
While the availability of mortgage financing for investment properties is extremely difficult, there is still capital available for financing single-tenant properties that are occupied on a long-term basis by tenants with very strong credit. The capital markets view these mortgages as more of a ‘corporate-financing’ vehicle than a ‘property-backed’ vehicle, which allows them to largely ignore traditional loan-sizing metrics such as loan-to-value ratios and debt service-coverage ratios. Instead, the focus is on using nearly all of the cash flow from the property to service the debt. 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(s) and the property, and are generally non-recourse to the borrowers. Even in today’s financing environment, it is possible to obtain mortgage financing of 90% to 95% on properties with long-term leases (at least 20-years remaining on the lease) with tenants which have very strong credit.
These zero-coupon programs typically combine several qualifying properties into a Delaware Statutory Trust (‘DST’) structure whereby investors can choose to invest either all of the equity from their relinquished property (if that is enough to cover their exchange), or exactly the amount of equity that they need to complete their 1031 exchange, thereby continuing to defer taxes in accordance with Section 1031. Such a DST offering can have up to 99 investors and may be available to investors with minimum individual equity investments under $50,000 (which might cover as much as $500,000 of debt).
While the purpose of these DST offerings may be to provide investors with a way to complete a 1031 exchange with minimal equity, there are likely to be significant tax implications during the holding period of the properties. 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 this DST offering structure uses all (or most) of the operating income to service the mortgage payments, there is typically little or no cash flow available for distributions to the investors. This leads 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.
So why would one participate in such an investment? Well, remember that upon the sale of the relinquished property, many investors will owe more in taxes than they receive from the sale of their relinquished property. If they write a check for the difference, the money is gone forever and the investor has nothing to show for it. For example, if an investor receives $100,000 cash from the sale of their property, but has a tax obligation of $200,000 they will need to come up with the additional $100,000 and they will have no way of recovering their money.
If, on the other hand, that same investor uses the $100,000 sales proceeds to invest in a zero-coupon investment, they will own real estate that pays off the mortgage automatically, leaving a building free and clear of debt when the lease expires. Even if the investor pays $100,000 in taxes on phantom income during the holding period they will still have the free and clear value of the real estate (albeit, perhaps vacant) upon the expiration of the lease.
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. © 2020 Legal 1031 Exchange Services, LLC. All rights reserved.