Potential Benefits with a Zero Coupon DST

The struc­ture of a Delaware Statu­to­ry Trust (DST) zero coupon may offer a vari­ety of ben­e­fits to investors.

June 1, 2024

By Al DiNi­co­la, AIF®, CEPA™
DST 1031 Spe­cial­ist
NAMCOA® — Naples Asset Man­age­ment Com­pa­ny®, LLC
Secu­ri­ties offered through MSC-BD, LLC Mem­ber of FINRA/SIPC

Cer­tain investors may be seek­ing a solu­tion to off­set tax­es, some investors seek debt replace­ment, pre­dictable cash flow, and oth­er need to off­set lever­aged prop­er­ties and oth­er solu­tions. These ben­e­fits may help in design­ing pro­grams that can assist in estate plan­ning. Not all the ben­e­fits will appeal to every investor and occa­sion­al­ly investors only seek to uti­lize one ben­e­fit.

What is a Zero Coupon. The struc­ture of near­ly all DST Zeros typ­i­cal­ly have many of the same com­po­nents.  The ref­er­ence to Zero ref­er­ences the dis­tri­b­u­tion that is typ­i­cal­ly paid. This may be sim­i­lar to a zero-coupon bond which is typ­i­cal­ly sold at a dis­count and upon matu­ri­ty is redeemed at full face val­ue. In the DST con­no­ta­tion the zero rep­re­sents the amount of dis­tri­b­u­tion paid name­ly zero (or close to zero). In many struc­tures the DST by design has a high degree of lever­age. The high degree of lever­age enables an investor to sat­is­fy debt replace­ment require­ments of the Sec­tion 1031 tax deferred exchange. We will expand on that advan­tage.

Here is an overview of the poten­tial advan­tages.

1. Defer­ring Tax­es uti­liz­ing a §1031 Exchange

• DSTs have been an accept­able (and recent­ly pre­ferred by many) as a suit­able replace­ment property.Compatibility with and between like kind exchanges make it a seam­less trans­ac­tion.  Zero coupon DSTs may not come to the top of the list for all investors when seek­ing an exchange because of the struc­ture. How­ev­er, this option does become part of the solu­tion in sev­er­al sit­u­a­tions. The tax sav­ings (defer­ral) of the §1031 in com­bi­na­tion with the DST pro­vides the alter­na­tive.

2. Sim­ple Cash Flow (Lack there­of)

• Income Redi­rect­ed: The struc­ture of the zero coupon DSTs uti­lizes the income typ­i­cal­ly gen­er­at­ed and dis­trib­uted to the investors and redi­rects the income to sat­is­fy­ing and pay­ing the mort­gage on the prop­er­ty.  In many cas­es the prop­er­ty is high­ly lever­aged. This pro­vides an allo­ca­tion of tax deduc­tion to the investors in the form of inter­est write offs. As the loan is paid off there may be a buildup in equi­ty if the loan is an amor­tized loan.  Amor­tized loans may have less inter­est to deduct on a per­cent­age basis.  The suit­abil­i­ty of this type of invest­ment would be for accred­it­ed investors who do not need reg­u­lar income. In most DST income is dis­trib­uted on a month­ly basis.  The zero with­out a dis­tri­b­u­tion may accu­mu­late addi­tion­al equi­ty as the loan is retired.
• Pre­dictable Return: The zero-coupon struc­ture pro­vides a known future pay­out, mak­ing finan­cial plan­ning more pre­dictable.

3. Gen­er­a­tional Wealth & Estate Plan­ning

• The End: A top­ic that enters the dis­cus­sion may be what hap­pens when the investors pass­es away.  The invest­ment real estate held by the investor upon their death will more than like­ly pass on to the heirs or anoth­er des­ig­nat­ed enti­ty. (Some investors will estab­lish char­i­ta­ble giv­ing using a DST as the vehi­cle).  When this hap­pens there is a step up in basis to the cur­rent mar­ket val­ue.  For exam­ple, if the investor pur­chased a prop­er­ty for $500,000 and held for 30 years it is more than like­ly that prop­er­ty may be ful­ly depre­ci­at­ed. As a side note the prop­er­ty could rep­re­sent mul­ti­ple prop­er­ties acquired and sold through a series of §1031 exchanges. If the $500,000 prop­er­ty (with zero basis) is sold for $3M there would be con­sid­er­able tax­es due, how­ev­er the prop­er­ty basis would reset to the cur­rent val­ue ($3M) regard­less of the depre­ci­a­tion tak­en by the investor who has passed away.
• DST Asset Con­sol­i­da­tion: DSTs (includ­ing zero coupon) may enable an investor to sell mul­ti­ple prop­er­ties and exchange into a sin­gle DST invest­ment. This may help sim­ply the invest­ment.  Alter­na­tive­ly, the oppo­site may also be accom­plished by the investor sell­ing a sin­gle asset and diver­si­fy­ing into sep­a­rate DST own­er­ship inter­est (in the same asset or prop­er­ty or dif­fer­ent prop­er­ties). Prop­er plan­ning may assist in the admin­is­tra­tion of the estate. 

4. Sim­pli­fied Investor (Pas­sive) Man­age­ment

• Pro­fes­sion­al Man­age­ment: As investors move from active to pas­sive man­age­ment (by design or demand) there is a need for pro­fes­sion­al man­age­ment. The advan­tage for investors would be DSTs are pro­fes­sion­al­ly man­aged.
• All day-to-day oper­a­tions as well as over­all asset man­age­ment is han­dled by the spon­sor of the DST. Investors who still pre­fer to be active would not be suit­able for a DST.  

5. Cost Seg­re­ga­tion Poten­tial

Addi­tion­al Study- Some DST will uti­lize part of the 2017 Tax and Jobs cuts act to take advan­tage of one of the aspects called cost seg­re­ga­tion. Cost seg­re­ga­tion (stud­ies) sim­ply put will ana­lyze the dif­fer­ent com­po­nents of the prop­er­ty and splits into dif­fer­ent buck­ets for depre­ci­a­tion cal­cu­la­tions.  This may accel­er­ate the depre­ci­a­tion tak­en or com­press depre­ci­a­tion into a short­er peri­od of time.  In some cas­es, the com­pres­sion of depre­ci­a­tion may cre­ate an extra amount of tax loss that could off­set income.  Cur­rent­ly in 2024 the cost depre­ci­a­tion could be as high as 60%.  Mean­ing a dol­lar invest­ed may result in a $1.60 in tax off­set. The cau­tion may be that the depre­ci­a­tion tak­en may be required to be recap­tured at a cer­tain time, IF there are no more §1031 exchanges enter into by the investor.  Alter­na­tive­ly, there are oth­er dif­fer­ent exit strate­gies (such as oppor­tu­ni­ty Zones) that may assist the investor with avoid­ing the recap­ture of depre­ci­a­tion.  Tim­ing is very impor­tant.

Cash Investors may also ben­e­fit.  The JOBS Act does have a declin­ing per­cent­age for uti­liza­tion of the cost seg­re­ga­tion ben­e­fits.  Cur­rent­ly at 60% in 2024 and reduced to 40% in 2025 and 20% in 2026 upon expi­ra­tion of the act unless extend­ed or renewed. Cash investors who have oth­er pas­sive income may off­set the income with invest­ment in a ZERO coupon espe­cial­ly if tak­ing the Accel­er­at­ed Depre­ci­a­tion in year one (2024).

6. Long-Term Appre­ci­a­tion Poten­tial

• Appre­ci­a­tion Poten­tial: Many investors seek real estate as a non-cor­re­lat­ed asset class and would like to see appre­ci­a­tion in the val­ue of the asset. DSTs (includ­ing Zero DSTs) can appre­ci­ate over time. With the Zero struc­ture that retired the debt on the prop­er­ty there could also be a buildup of equi­ty real­ized on the sale of the prop­er­ty.  As with all real estate the investors need to be aware of the pro­ject­ed hold­ing peri­od. DSTs are con­sid­ered an illiq­uid asset class.

7. Diver­si­fi­ca­tion

• Diver­si­fi­ca­tion: By nature, a DST may attract investors who seek diver­si­fi­ca­tion across geo­graph­ic loca­tion and types of prop­er­ties. Diver­si­fi­ca­tion may assist in mit­i­gat­ing risk but is not guar­an­teed to elim­i­nate risk.  Some Zero DST may have a port­fo­lio of assets pro­vid­ing diver­si­fi­ca­tion with­in a sin­gle DST offer­ing.

8. The Exit Strat­e­gy

• Pro­ject­ed Matu­ri­ty Date: All DST will have a pro­ject­ed matu­ri­ty or sale date. While there are no guar­an­tees spon­sors will seek the opti­mal sit­u­a­tion to max­i­mize returns for the investors.  The spon­sors will be incen­tivized to obtain the great­est returns.  The exit strate­gies are typ­i­cal­ly defined in the Pri­vate Place­ment Mem­o­ran­dum (PPM).  The long-term aspect of the asset may assist in long term plan­ning.

9. 1031 Debt Replace­ment

• Non-Recourse Debt Allo­ca­tion: As an IRC 1031 require­ment debt retired on the relin­quished prop­er­ty must be replaced with new debt (or cash) to avoid pay­ing boot on the loan sat­is­fied on the sale.  Investors are pleased with the debt struc­ture on DST being non-recourse.  The debt is prepack­aged and assigned based on the amount of equi­ty being acquired. Zero coupon DST that have a large amount of lever­age enable investors wo sat­is­fy debt replace­ment with few­er dol­lars.  For exam­ple, one investor sold a prop­er­ty for $1.6m and received $800k in cash and retired $800k in debt.  Uti­liz­ing a Zero Coupon DST the debt was sat­is­fied with an equi­ty allo­ca­tion of $170k.  This enabled the investors to pur­chase two tra­di­tion­al rental homes (for all cash) with the remain­ing bal­ance of $630,000. There was no need to apply for financ­ing or sign on the loan for the DST zero.

Sum­ma­ry

The spe­cif­ic aspect of the zero-coupon DSTs is not for all investors but can be an attrac­tive option for cer­tain investors. Investors seek­ing alter­na­tives for tax defer­ral, estate plan­ning ben­e­fits, and a pas­sive, long-term invest­ment with pre­dictable out­comes may want to review. Suit­abil­i­ty is always a con­cern we have for each investor. Con­sult your tax pro­fes­sion­al for spe­cif­ic needs.

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.

Thank you.