Case Study: The Zero DST
A 1031 exchange is essentially a swap of one investment property for another. The advantage of using a 1031 exchange is that it allows you to defer capital gains on appreciated investment property.
There are a number of factors to consider when doing a 1031 exchange, including potential tax implications for any debt on the exchanged property.
Enter the 1031 exchange Zero Income DST (Delaware Statutory Trust).
A Zero DST is a form of 1031 exchange that provides a debt option to help avoid the unwanted tax implications of reduced debt that can result from a 1031 exchange.
Let’s take a look at a case study from a client who we recently helped through this process.
Morgan’s situation
Morgan was doing a $1.7 million 1031 exchange with about $933,000 in debt. That left $767,000 in cash at the Qualified Intermediary (QI).
I received a call from Morgan and after a brief introduction and back-and-forth, he paused and asked, “Did I screw up my exchange?” Note this is the PG-13 version of what he actually asked.
This was the beginning of the educational process. I started Morgan’s education by explaining to him that he needed to get a loan for $933,000 and is required to replace the debt that was paid off as part of the 1031 exchange. In a 1031 Exchange you have to replace the equity and the debt. So if you closed a sale at $1.7 million that had $$933,000 in debt, you have to purchase $1.7 million of like-kind replacement real estate which includes $933,000 of debt.
You see… Morgan had outlined his “plan” which sounded great, but I asked him, “what about the debt?” Where’s the $933,000 in debt – he interrupted, “I paid that off!” No laughing allowed. That’s when I had to explain to him the requirement of having to replace the debt/loan in his new purchase(s). You can probably hear, the “OOOOOH… really?” yourself while reading this.
Morgan already purchased one property for $420,000 all cash. He was in contract for a second property for $207,000 which was to close very soon. For both properties he was planning to use all-cash to make the purchases.
What was missing in those two transactions was that there was no debt.
Using a Zero coupon DST
What a Zero coupon DST does is provide the debt needed without having to go and get a new loan. The Zero although it provides no income, it gives you all of the debt and depreciation as if you actually had a $933,000 loan.
Morgan purchased $204,000 of a Zero Coupon DST program which was the equivalent of $934,000 of debt; which covered all of the debt from his old property. Problem solved, this eliminated virtually all of the taxes he would have faced on the elimination of the $933,000 in debt.
Morgan was like many real estate investors who are unaware of the potential tax hit from not replacing the debt eliminated from the property that is being exchanged. This can cause a 1031 exchange to literally “blow up” in an investor’s face.
If you’re considering slowing down and spending more time with your spouse/partner, the grandkids, traveling or just not dealing with the tenants, toilets, and trash, and the other headaches that can come with owning income property, let’s set up a time to talk about what that looks like.
It’s easy to schedule a meeting. My calendar is as close as the “Calendly” link below. Copy the link into a browser and schedule a meeting today.
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This is for informational purposes only, does not constitute as individual investment advice, and should not be relied upon as tax or legal advice. Please consult the appropriate professional regarding your individual circumstance.
The case study is for illustrative purpose only. Individual results will vary.
There are material risks associated with investing in DST properties and real estate securities including liquidity, tenant vacancies, general market conditions and competition, lack of operating history, interest rate risks, the risk of new supply coming to market and softening rental rates, general risks of owning/operating commercial and multifamily properties, short term leases associated with multi-family properties, financing risks, potential adverse tax consequences, general economic risks, development risks, long hold periods, and potential loss of the entire investment principal.
DST 1031 properties are only available to accredited investors (typically have a $1 million net worth excluding primary residence or $200,000 income individually/$300,000 jointly of the last three years) and accredited entities only. If you are unsure if you are an accredited investor and/or an accredited entity please verify with your CPA and Attorney.
