DST Zero Coupon May Add Value.

For the right investor a Delaware Statu­to­ry Trust (DST) zero coupon may be suit­able.  The struc­ture and func­tion of the zero coupon may solve many issues of com­pli­ance an investor faces with a §1031 tax deferred exchange.

By Al DiNi­co­la, AIF®, CEPA™
Decem­ber 10, 2023
Adinicola@namcoa.com
DST 1031 Spe­cial­ist
NAMCOA® — Naples Asset Man­age­ment Com­pa­ny®, LLC
Secu­ri­ties offered through MSC-BD

Cer­tain investors may be seek­ing a spe­cif­ic tax ben­e­fit (if the investor qual­i­fies) with the acqui­si­tion of a zero-coupon DST. Suit­abil­i­ty and diver­si­fi­ca­tion may be two rel­e­vant posi­tions when doing due dili­gence.

You may have heard of zero-coupon bonds.  These are bonds typ­i­cal­ly sold at a dis­count of their face val­ue with no “coupon pay­ments” or inter­est paid to the investor dur­ing the hold­ing peri­od.  At the end of the term when the bond matures the investor receives the full face val­ue of the bond.  This may also be ref­er­enced as an accru­al bond.

The zero-coupon DST are dif­fer­ent than a reg­u­lar DST in one aspect of their struc­ture since there are no dis­tri­b­u­tions paid to the investor dur­ing the hold­ing peri­od.  Typ­i­cal­ly, the dis­tri­b­u­tions in a zero-coupon are uti­lized to pay debt ser­vice and the prin­ci­pal loan amount.  How­ev­er, the zero-coupon DST can pro­vide advan­tages for debt replace­ment, depre­ci­a­tion, and long-term poten­tial growth.  With the Tax and Jobs act of 2017 there is also the poten­tial abil­i­ty to uti­lize a cost seg­re­ga­tion to enhance pas­sive income off­set.

What is a Zero-Coupon DST

• The assets are typ­i­cal­ly leased to a high cred­it ten­ant.
• The lease is a triple net lease (NNN)
• As men­tioned, the investor does not direct­ly receive any dis­tri­b­u­tion since the rents received from the ten­ants are used to pay down the mort­gage on the prop­er­ty.
• When the prop­er­ty is sold there is a build up of equi­ty as the mort­gage or loan is paid down.

Zero-Coupon DSTs are not com­mon.  Over the past three to four years, we have reviewed over 400 DST pri­vate place­ment mem­o­ran­dums (PPM). Dur­ing that time there may have been less than twen­ty (20) zero-coupon DST offer­ings. Many of the offer­ings were large ten­ants like Ama­zon, FedEx, very large insur­ance com­pa­nies, and oth­er cred­it wor­thy ten­ants.  Some of the build­ings are pur­pose built and the ten­ant improve­ment, with spe­cif­ic automa­tion require­ments, may exceed the price of the build­ings them­selves.  The ten­ant improve­ments are paid for by the ten­ants. Imag­ine the inte­ri­or build­out of an Ama­zon dis­tri­b­u­tion cen­ter or a mul­ti­mil­lion square foot auto parts facil­i­ty. The ten­ant is total­ly com­mit­ted to a long-term lease. Twen­ty-to-thir­ty-year leas­es are not uncom­mon.

So when can you use a zero-coupon?
The design of a typ­i­cal DST is not for every investor and that is also true about a zero-coupon DST.  How­ev­er, there are sit­u­a­tions where a zero coupon may align with the investor goals. Besides align­ing with investors goals the zero coupon may sat­is­fy the §1031 require­ments and save time and mon­ey.

Val­ue appre­ci­a­tion of the asset
Since the struc­ture of the zero allo­cates the typ­i­cal cash flow dis­tri­b­u­tion towards pay­ing off the mort­gage debt there will be an increase in equi­ty posi­tion in the prop­er­ty.  The more equi­ty in the asset the more poten­tial prof­it may be real­ized.

Not much cash – not a prob­lem
We have seen investors refi­nance their invest­ment prop­er­ty well before the §1031 exchange was entered into or even con­tem­plat­ed. Over the past year inter­est rates have risen and investors who extract­ed cash out of their invest­ment at low­er inter­est rate uti­lized the cash but now have a high­er loan amount.  That loan amount needs to be replaced to com­ply with the §1031 exchange require­ment.  Debt needs to be replaced with new debt (or addi­tion­al cash).  With the rise of inter­est rates in the past year many typ­i­cal DST spon­sors have decreased the amount of loan to val­ue (i.e. more con­ser­v­a­tive under­writ­ing). The low­er loan to val­ue may make it more dif­fi­cult for investors to find suit­able debt replace­ment prop­er­ty.  The zero-coupon DST cre­ates oppor­tu­ni­ties.

The high­er lever­aged DST may be attrac­tive to an investor enabling increased poten­tial tax con­sid­er­a­tion or write offs.  Espe­cial­ly if the basis in the relin­quished prop­er­ty is very low.

Dur­ing 2022 and part of 2023, replace­ment inven­to­ry was under sup­plied in many areas of the coun­try.  Cash offers and above ask­ing price offers were com­mon. One of our investors want­ed to acquire rental homes in their local area but was sad­dled with debt that need­ed to be replaced. The cash pro­ceeds from the relin­quished prop­er­ty were about $800,000.  The debt need­ing to be replaced was about the same, $800,000. Using a high­ly lever­aged zero coupon DST a cash invest­ment of $140,000 cre­at­ed a debt of $800,000. This sat­is­fied the §1031 exchange debt require­ment.  The bal­ance of cash $660,000 ($800,000 minus the $140,000) was used to make cash offers on two small rental homes.

The attrac­tion of the zero- coupon DST may be in the qual­i­ty of the ten­ant and the long-term lease arrange­ments.

Cost Seg­re­ga­tion Advan­tage
The short com­ment regard­ing a zero-coupon DST is to check your pas­sive income from oth­er invest­ments.  Cer­tain DST spon­sors will con­duct cost seg­re­ga­tion analy­sis enabling investors to achieve an inter­est­ing off­set of pas­sive income with the mul­ti­ple gen­er­at­ed with the cost seg­re­ga­tion appli­ca­tion.  There is a declin­ing per­cent­age of off­set.  In 2023 the off­set may be as high as a 1.6 mul­ti­ple. Putting that in dol­lar terms a $1M invest­ment in a zero-coupon DST may gen­er­ate $1.6M in accel­er­at­ed depre­ci­a­tion (write off) that may be used against oth­er pas­sive income.

What are the risks?
As with all invest­ments there are con­sid­er­a­tions regard­ing the draw­backs. Since there are no dis­tri­b­u­tions being made to investors all pay­ments are going to pay down the loan. Under a typ­i­cal real estate invest­ment, income received is off­set by depre­ci­a­tion and any inter­est pay­ments being made on the mort­gage.  As a reminder DSTs have non-recourse loans.  In the zero-coupon (high­ly lever­aged) DST, the oper­at­ing income is off set by the tax advan­tages of depre­ci­a­tion and inter­est pay­ments.  

The beau­ty of invest­ment real estate is that over the years the property’s debt will be paid down. If the mort­gage is a ful­ly amor­tized loan (not an inter­est only loan) the inter­est write offs will be reduced and the result will be poten­tial­ly high­er income. In a zero coupon you are not receiv­ing any income which may cre­ate a prob­lem. 

Enter the Phan­tom.
There is a sit­u­a­tion referred to as phan­tom income.  The IRS con­sid­ered income you are not receiv­ing and con­sid­ers you respon­si­ble for your share of pro­rat­ed tax­es. Each indi­vid­ual investor will need to ana­lyze their basis in their prop­er­ty and deter­mine if any tax­es may be due.

Required Due Dili­gence
All DST invest­ments require due dili­gence, and the zero-coupon DST is no dif­fer­ent. There are cer­tain sit­u­a­tions where the zero DST may solve a prob­lem cre­at­ed by the investor.  The prob­lem may have been a high­ly lever­aged relin­quished prop­er­ty or a cash out refi­nanc­ing. In some cas­es, the investor may need to add cash to the replace­ment exchange to sat­is­fy the met­rics of the exchange.  As always, we sug­gest con­sult­ing with a finan­cial advi­sor. If the right steps are not fol­lowed or if the exchange is not bal­anced with the right com­bi­na­tion of equi­ty and debt the exchange may not be accept­able to the IRS and may result in sig­nif­i­cant tax lia­bil­i­ties.

DSTs are not for all investors.  The acqui­si­tion of a DST is for accred­it­ed investors only.  Con­tact your invest­ment advis­er for addi­tion­al details on how a DST may be a solu­tion to your 1031 Exchange and suit­ed for your invest­ment future. For more infor­ma­tion on how to prop­er­ly set up an IRC 1031Tax Deferred Exchange or if you are an accred­it­ed investor and would like addi­tion­al infor­ma­tion on a DST con­tact Al DiNi­co­la at 239–691-8098 or email adinicola@namcoa.com.

This is not an offer to pur­chase or solic­i­ta­tion to pur­chase any secu­ri­ty, as such be made only through an offer­ing mem­o­ran­dum or prospec­tus.  Invest­ing in secu­ri­ties, real estate, or any invest­ment, whether pub­lic or pri­vate, involves risk, includ­ing but not lim­it­ed to the poten­tial of los­ing some or all of your invest­ment dol­lars when you invest in secu­ri­ties. You should review any planned finan­cial trans­ac­tions that may have tax or legal impli­ca­tions with your per­son­al tax or legal advi­sor.   NAMCOA, LLC is a Reg­is­tered Invest­ment Advi­sor, reg­u­lat­ed by SEC (Secu­ri­ties and Exchange Com­mis­sion). Our cor­po­rate office is locat­ed at 999 Van­der­bilt Beach Road, Suite 200, Naples Flori­da 34108. Secu­ri­ties Offered through MSC-BD, LLC, Mem­ber of FINRA/SIPC. 8215 SW Tualatin- Sher­wood Rd, Suite 200, Tualatin, OR 97062.  MSC-BD, LLC and NAMCOA are inde­pen­dent­ly owned and are not affil­i­at­ed.

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