What happens at the end of a zero cash flow DST's loan?

The lease pays the loan; when both run out, the trust's job is done

Our cash out DSTs hold triple-net leased property backed by investment-grade tenants on long-term leases, financed with non-recourse debt. All income from operations goes to servicing and amortizing the loan, so investors receive no current distributions and are paid through potential appreciation and a payout on sale.

Rev. Rul. 2004-86 shows why the loan and lease tend to end together. Its facts pair a 10-year net lease with a 10-year nonrecourse loan, and the ruling says that if the trustee could "renegotiate the lease" or "renegotiate or refinance the obligation used to purchase" the property, the trust would become a business entity taxed as a partnership.

So a trust built around one lease and one loan has no way to extend itself. When the lender is paid and the lease term ends, the sponsor sells, or uses whatever exit the trust agreement provides. Whether your trust amortizes fully or leaves a balloon is in the loan summary of the private placement memorandum; read it before you subscribe.

Paid-down principal is your equity, and the deferred gain rides on top of it

Principal repayment never touched your basis. When the trust bought the property with borrowed money, the loan was part of the cost, and the Supreme Court in Commissioner v. Tufts explained that loan proceeds are not income and that repayment "likewise has no effect on his tax liability." Depreciation, meanwhile, kept lowering your basis every year.

The result at sale is a large gain against a small original check. Your amount realized is your share of the price; your adjusted basis is the low basis you carried in from the property you sold, plus your share of the debt-financed cost, minus the depreciation you claimed.

That is the deferral finally reaching the surface. If you take the cash, the depreciation portion is unrecaptured section 1250 gain taxed at up to 25%, the rest is long-term capital gain, and the 3.8% net investment income tax applies above $250,000 of modified adjusted gross income for joint filers or $200,000 for single filers.

Hypothetical: a fully amortized zero against one with a balloon

Round numbers, hypothetical, for illustration only. You put $200,000 of exchange equity into a zero at 85% leverage, so your share of the property is about $1,333,000 with about $1,133,000 of debt. Years later the trust sells and your share of the price is $1,400,000. Assume your adjusted basis in the position by then is $500,000.

If the loan amortized to zero, you receive $1,400,000 of cash and have a $900,000 gain. To defer all of it, you exchange the whole $1,400,000 into property costing at least that much; there is no debt relief to replace.

If a $400,000 balloon is paid at closing, you receive $1,000,000 of cash and are relieved of $400,000 of debt, which Reg. section 1.1031(d)-2 treats as money received. The gain is still $900,000, and to defer it you buy at least $1,400,000 of property, taking on $400,000 of new debt or adding that much cash. Run your own numbers with your CPA.

Three ways out: another exchange, a 721 contribution, or a taxable sale

Another exchange works the same way it did going in. The qualified intermediary must be in place before the trust's sale closes, and the 45-day and 180-day periods of section 1031(a)(3) run from that closing. Our page on the DST sale and your next 1031 covers the coordination with the sponsor.

Some offerings provide for contributing the property to an operating partnership instead. Section 721 lets that happen without gain, but the units you receive are partnership interests, which Reg. section 1.1031(a)-3(a)(5) lists as not real property, so the 1031 chain ends there; see the 721 UPREIT exit.

A taxable sale is the right answer for some owners, usually when the gain is modest relative to their bracket or the cash is needed. For a long-held, heavily depreciated position, it is usually the most expensive of the three.

• Ask the sponsor for the projected sale window, not just the loan maturity date.
• Line up an intermediary and replacement candidates months before that window opens.
• If you are older or in poor health, compare exchanging again with holding through the trust's life, because a basis step-up at death applies only to what you still own.
• Plan cash for any tax that a partial exchange will leave behind.

What can go wrong before the end: the tenant, not the calendar

The plan assumes the tenant pays every month until the loan is gone. If it stops, the trustee can re-lease only in the tenant's bankruptcy or insolvency, and a lender foreclosure on a nonrecourse loan is still a sale for tax purposes: Reg. section 1.1001-2 includes the discharged nonrecourse debt in your amount realized. That can produce a large taxable gain with no cash.

The zero cash flow DST explainer lists the risks in full, and the springing LLC answer explains what a conversion would do to your exit. Ask your CPA or attorney to model the end-of-loan sale with your actual basis before you subscribe.