HOW YOUR 1031 EXCHANGE CAN BENEFIT FROM A “ZERO” DEAL

In previous blog posts I’ve discussed benefits of entering into a 1031 exchange. Also known as a like-kind or tax deferred exchange, a 1031 exchange affords significant tax benefits to property owners.

Specifically, a 1031 exchange allows a taxpayer to sell an investment property and reinvest in replacement property(ies) while deferring ordinary income, depreciation recapture and/or capital gains taxes. By deferring tax on the transaction, taxpayers will have more cash available for reinvestment.

What is a zero cash flow purchase?

In a zero cash flow or “zero” deal, the net operating income on a net-leased property matches the debt service, and the loan amortization matches the term of the lease. If the property is retained for the full term of the lease, there is no debt at the end of the term.

Many real estate investors purchase zeros to offset taxable income from other investments through losses associated with depreciation deductions and interest expenses. These transactions are not without drawbacks, as taxable income will occur when the annual loan amortization exceeds the annual depreciation.

Benefits of a zero in a like kind exchange

One of the largest benefits of a zero in a like kind exchange is the pay-down or re-advance feature, whereby the buyer can access cash from the exchange without triggering gain recognition. Once the property is acquired and the exchange is completed, the loan provides the owner an option to refinance a portion of the equity. The options are exercised within the existing loan documents, and there is no renegotiation of terms with the lender. The proceeds can then be deployed to cash-flowing assets.

For example, a taxpayer has a property worth $10 million, comprised of $4 million in equity and $6 million in debt. She found a zero property that can be purchased for $10 million, putting down $1 million as equity and assuming $9 million of debt. The buyer applies $4 million in cash to purchase the replacement, covering the equity requirement of the 1031 exchange. Of that, $3 million (excess of the $4 million of equity from the down-leg over $1 million of equity required for purchase of the property) is used to pay down the debt balance. The interim debt balance is $6 million, fulfilling the debt requirement of the buyer’s 1031 exchange. After closing, the debt is re-advanced from $6 million to the original $9 million, with loan proceeds of $3 million going to the buyer. The exchange has been completed, income deferred and the taxpayer has extracted $3 million in non-taxable proceeds.

If you’re interested in structuring a 1031 exchange as a zero cash flow purchase, be sure to consult a real estate broker who specializes in these investments. You’ll also want to coordinate the deal with your tax advisor so that you’re following all the 1031 exchange rules.