A Zero-Coupon Delaware Statutory Trust (DST) is an investment that does not pay any distributions – but which can help some investors achieve important benefits that can outweigh the loss of ongoing income.
The underlying real estate in a Zero-Coupon DST is typically a single tenant property occupied by a larger tenant with an established credit rating such as Amazon or Verizon. Lease terms are commonly 20-years with multiple extension options and rent payments, property maintenance, and expenses are guaranteed by the tenant. These DSTs are created and managed by generally well-established sponsors who have a good financial profile. The combination of the tenant’s credit rating, lease guarantee, and sponsor profile allows lenders to provide loans ranging from 80% to 90% of the value of the property.
All the net income of the property is used to pay down the loan over the holding period and, when the property is sold, the investor should expect (but there can be no assurance) to receive their original investment plus additional equity due to the portion of the loan that was paid off during the holding period plus any appreciation that may have occurred. Future sales proceeds from a Zero-Coupon DST can be deferred via a 1031 exchange.
Zero-Coupon DSTs may be fit to help solve two problems.
Overcoming Challenges of Selling Assets with High Debt
Several of our clients refinance their rental properties from time to time to obtain funds for other purposes. Money received in the form of a loan is tax-free and can generally be used for anything that the investor chooses to purchase, e.g., a new car, college tuition, property improvements, a longed-for vacation trip, etc. We have seen more refinancing activity in recent years due to clients desiring to free up trapped equity resulting from property appreciation and to take advantage of historically low interest rates.
Investors who have refinanced their properties may be faced with challenges in completing a 1031 exchange at time of sale. Remember that one of the rules for completing a full tax deferral is that the investor must replace the debt in the sold property with either new debt in the replacement properties or with cash from outside the exchange.
An investor who is selling a property with a higher debt ratio e.g., 60% or greater, may find that they are unable to qualify for a new loan of equal or greater value and therefore may be stuck paying taxes on the portion of the loan that they cannot replace in their new properties. DSTs can be a good option to consider except for the fact that most DSTs have loan to value ratios that are below 60%.
Here is an example of where the Zero-Coupon DST may be good fit. Let’s suppose an investor sold a property with a 70% debt ratio and wishes to reinvest in DSTs with an average debt ratio of 55%. Rather than paying the taxes that would otherwise be owed due to acquiring properties with lesser debt, they could invest a portion of their funds in a Zero-Coupon DST and blend the higher 80% to 90% debt ratio in that DST with other properties having lower debt. The result could be that no (or lesser) funds are lost to taxes and the investor is able to acquire some income producing properties with lower debt ratios.
Potential Long-Term Results May Be Attractive
We occasionally have clients who have sufficient income and are looking for a relatively secure investment that can produce an attractive capital gain over the holding period. Due to the relatively rapid pay-down of the loan in a Zero-Coupon DST plus possible appreciation of the underlying asset, the total return may be more attractive than other investments begin considered.
Consider Impact of Phantom Income
As the Zero-Coupon DST is paid down, there will typically be a point in time when the property’s income will exceed the loan’s interest expenses and the loan will begin to be reduced resulting in a pay-down of the principal. Pay-down of principal is considered taxable income by the IRS. Since no distributions will be paid during the holding period, the investor may need to come out-of-pocket to pay taxes owed on this so-called phantom income.
Summary
The Zero-Coupon DST is a specialized offering that can solve problems faced by some investors. It can be especially appealing to investors selling properties with high debt ratios. Rather than losing funds to pay taxes, funds can remain in one’s estate. While the loss of income during the holding period can be a downside, investing in a Zero-Coupon DST may prove to be the lesser of two evils as compared with paying taxes.
Investing in a Zero-Coupon DST can involve added considerations that may require inputs from your tax advisor and/or estate planning professionals plus the support of a knowledgeable DST representative who help you determine suitability for your circumstances. We always recommend that clients obtain inputs from their tax advisors before investing in DSTs.
For more information on tax deferral strategies,1031 exchanges and 1031 replacement property options including traditional real estate and DSTs, please visit our website at www.FGG1031.com or contact us via phone 408 392-8822 or by email at info@FirstGuardianGroup.com to book an appointment.
We look forward to assisting you to make wise and informed investment decisions.
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