Why does a zero cash flow DST create phantom income: taxable income with no cash?

The trust is invisible for tax, so its rent and its loan are treated as yours

A properly limited DST is a grantor trust. Rev. Rul. 2004-86 holds that each investor is treated as owning an aliquot portion of the trust and that "all income, deductions, and credits attributable to that portion are includible" in the investor's taxable income under section 671. You report your share of the rent and expenses as if you owned that slice of the building and its mortgage directly.

That is helpful for the exchange, because it makes the interest real property. It also means you report income the moment the tenant pays rent, whether or not any of it reaches you.

In our cash out DSTs, all operating income goes to servicing and amortizing the debt, so none of it reaches you during the hold. That is the setting where phantom income appears.

Principal is the deduction that does not exist

Publication 527 states the rule without exceptions: "You can't simply deduct your mortgage or principal payments." Interest is deductible on a rental, principal is not, because repaying a loan has no effect on your taxable income. The Supreme Court made the same point in Commissioner v. Tufts: loan proceeds are not income, and repayment "likewise has no effect on his tax liability."

On an amortizing loan, each payment shifts from mostly interest to mostly principal. With rent fixed and fully committed to the lender, the interest deduction shrinks every year and taxable income grows by the same amount.

Depreciation is the offset. A triple-net lease leaves few other expenses, so depreciation is usually the only large deduction besides interest.

Depreciation shields the early years, on two different clocks

How much depreciation you get depends on your basis. Under Reg. section 1.168(i)-6, the basis you carried over from the property you sold keeps depreciating over that property's remaining recovery period, and any excess basis, such as the debt-financed cost of the zero, is treated as newly placed in service and starts a fresh schedule. Publication 946 sets that schedule at 39 years for nonresidential real property.

Two consequences follow. A zero bought largely with borrowed money has a big excess basis, which gives a steady deduction for decades. But if your old rental was almost fully depreciated, the carried-over piece runs out within a few years and taxable income jumps the year it does.

Ask your CPA to build the depreciation schedule on day one, using your actual carryover basis, so the step-up in taxable income is on the calendar rather than a surprise.

Hypothetical: a $1,000,000 share with all rent going to the lender

Round numbers, hypothetical, for illustration only. Your share of the property is $1,000,000 with $850,000 of debt. Your share of rent is $70,000 a year, all paid to the lender. Depreciation is $22,000 a year and trust expenses are negligible because the lease is triple-net.

In year one, interest is about $48,000, so taxable income is $70,000 minus $48,000 minus $22,000, or zero. By year ten, interest has dropped to about $30,000 and taxable income is $18,000. If a carried-over depreciation schedule ends in year eight and cuts depreciation to $15,000, taxable income in year ten is $25,000, every dollar of it without cash.

Run your own numbers with your CPA, using the loan schedule from the offering documents and your own basis.

Plan for the tax from other income, and size the zero to the debt you need to replace

Phantom income is passive rental income, so suspended or current passive losses from other rentals can absorb it, as our page on DST passive losses explains. It is also net investment income, subject to the 3.8% tax under section 1411 above $250,000 of modified adjusted gross income for joint filers or $200,000 for single filers; see DST income and NIIT.

The simplest control is size. A zero is there to carry debt with little equity, so the smallest slice that replaces your mortgage keeps the phantom income small, and income-paying trusts can hold the rest of the exchange and fund the tax. The traditional DST vs cash out DST guide works through that split.

• Get the loan amortization schedule and your share of it before subscribing.
• Have your CPA project taxable income for every year of the hold, not just year one.
• Set aside cash each year for the tax, or pair the zero with income-producing trusts.
• Remember that the principal paid down comes back to you as equity when the property sells.