The Zero Coupon DST: A Specialist Tool for the Heavily Leveraged Exchanger

Some investors sell property carrying far more debt than they want to take on again. Perhaps they refinanced several times over the years, or perhaps the property was always highly leveraged. When they sell, the 1031 rules require them to replace that debt, or add cash, to defer all of the gain.

Replacing large amounts of debt with conventional financing can be difficult or unwelcome. The zero coupon DST is a specialised structure designed to solve that specific problem.

What is a zero coupon DST?

A Delaware Statutory Trust that owns property, usually a net leased building with a long term creditworthy tenant, financed with very high leverage, often well above the levels used in conventional DSTs.

The tenant's rent is used almost entirely to pay the loan. As a result, investors receive little or no cash distributions. The loan is paid down over the lease term, ideally to a low balance by the time the lease ends.

The name comes from the similarity to a zero coupon bond: no regular payments, with value realised at the end.

Why would anyone want an investment with no income?

Because it solves the debt replacement problem efficiently.

Suppose you sell a property for 3 million dollars with a 2 million dollar mortgage. Your net equity is 1 million dollars. To defer fully, you need replacement property worth at least 3 million dollars with at least 2 million dollars of debt, or equivalent added cash.

A zero coupon DST with high leverage allows a relatively small amount of equity to carry a large amount of debt. You might place part of your equity in a zero coupon DST to satisfy much of the debt requirement, and the rest in conventional replacement property that pays income.

What is phantom income?

This is the key tax issue. Because the tenant's rent pays down loan principal, the trust earns taxable income even though investors receive little or no cash. Depreciation and interest deductions offset some of that income, particularly in early years, but as the loan amortises and interest falls, taxable income can exceed distributions.

Investors may owe tax on income they never received in cash. That is often called phantom income. It should be modelled before investing.

What are the risks?

• ›High leverage. Small declines in property value can wipe out equity.
• ›Tenant concentration. The structure depends on a single tenant paying rent for the full lease term. A default can be severe.
• ›No income. Investors must be comfortable with little or no cash flow for many years.
• ›Illiquidity. Like other DSTs, interests generally cannot be sold on demand.
• ›Exit uncertainty. Value at the end depends on the property, the remaining debt and whether the tenant renews.

Who is it suitable for?

Typically investors who:

• ›Must replace a large amount of debt to defer gain
• ›Have other sources of income
• ›Understand and can pay tax on phantom income
• ›Want to combine the structure with income producing replacement property
• ›Accept high leverage in exchange for tax deferral

It is rarely suitable as someone's only replacement property.

How is it usually combined with other property?

A common approach pairs a zero coupon DST with an all cash or modestly leveraged DST, or with a directly owned property. The zero coupon piece carries much of the debt requirement. The other piece provides income. Together, the total value and debt meet the exchange requirements.

What should you ask the sponsor?

• ›What is the loan to value, and how does it change over time?
• ›Who is the tenant, and how long is the lease?
• ›What happens if the tenant defaults?
• ›What is the projected taxable income each year compared with cash distributions?
• ›What is the expected outcome at the end of the lease?

What does a worked example look like?

An investor sells a property for 4 million dollars with a 2.8 million dollar loan. Net equity is 1.2 million dollars. To defer fully, the investor needs 4 million dollars of replacement property carrying at least 2.8 million dollars of debt, or must add cash.

The investor puts 400,000 dollars of equity into a zero coupon DST carrying high leverage, where that interest comes with, for example, 2 million dollars of allocated debt and 2.4 million dollars of property value. The remaining 800,000 dollars of equity goes into a conventional DST with 50 percent leverage, bringing 800,000 dollars of allocated debt and 1.6 million dollars of value.

Total value is 4 million dollars and total debt is 2.8 million dollars. The requirements are met, the investor receives income from the conventional DST, and the zero coupon piece carries most of the debt burden. The figures here are illustrative only; actual leverage and allocations vary by offering.

What to do first

Calculate how much debt you must replace and how much equity you have. Ask your CPA to model the phantom income over the projected hold. Only then consider whether a zero coupon structure, alone or combined with income producing property, fits your situation.

Nothing here is tax, legal or investment advice. DST interests are securities offered to accredited investors only through licensed broker dealers and definitive offering documents, and investing involves risk including loss of principal. Confirm your plan with your advisers before investing.