Is the cash from a zero cash flow DST refinance taxable?

Loan proceeds are not income because they come with a duty to repay

The reasoning in Tufts is short: 'When a taxpayer receives a loan, he incurs an obligation to repay that loan at some future date. Because of this obligation, the loan proceeds do not qualify as income to the taxpayer.' The same holds whether you borrow against your own building or receive your share of a trust-level refinance.

That is what our cash out DST page means by a tax-free refinance, with 80% to 90% of exchange value coming back as cash. It does not mean the gain you deferred in the exchange has gone away.

The tax arrives at the exit, measured by the loan as well as the cash

Your basis in the trust's property is the carried-over basis from the exchange, adjusted for depreciation. Borrowing more does not add to it, because nothing was spent on the property.

When the property is sold, Reg. Section 1.1001-2(a) includes 'the amount of liabilities from which the transferor is discharged' in the amount realized. The buyer's money repays the loan first, so your gain is measured on the full price while your cash is only what is left after the payoff.

If the property is lost to the lender instead, paragraph (b) says the value of the property is irrelevant and the full nonrecourse balance is treated as money received. A foreclosure can therefore produce a large taxable gain with no cash at all; DST leverage and interest-rate risk sets out the exposure.

Worked example: $450,000 of refinance cash on a $500,000 interest

Hypothetical, round figures. You exchanged into a zero cash flow DST with $500,000, carrying a low basis over from the property you sold. Your share of the later refinance returns $450,000, the top of the range our page describes. Nothing is taxed that year because of the cash.

Years later the property sells, and your share of the price just covers your share of the loan and leaves $60,000. Your gain is your share of the full price, loan included, minus your adjusted basis, so it can be several times the $60,000 you receive, and the tax on it may exceed that cash.

One answer to that is another exchange, which also requires replacing the debt the sale retires. Run your own numbers with your CPA.

Interest on the new loan follows the money, not the building

Reg. Section 1.163-8T allocates debt 'in accordance with the use of the debt proceeds', and interest follows that allocation; the property securing the loan does not decide it. If you spend the cash on a home or personal costs, interest allocated to that use is treated differently from interest on the rental itself.

In a zero cash flow trust the rent services the whole loan and you receive no distributions, so the treatment of the interest affects your taxable share of the trust's income directly. Ask your CPA how the refinance interest will be allocated before you decide how to use the cash.

Why these trusts produce taxable income with no cash even before a refinance is covered in the zero cash flow structure explained.

Keep the refinance clearly separate from the exchange

During the exchange the money is off limits. Reg. Section 1.1031(k)-1(g)(6) requires that you have no right to 'receive, pledge, borrow, or otherwise obtain the benefits' of the exchange funds before the exchange period ends. Cash received in the exchange itself is boot under section 1031(b).

The refinance cash is a different event only if it is one. Our pages place it after a defined period, as a step of the investment rather than of the exchange. Ask for the offering's tax opinion on that point, and on how the refinance fits Rev. Rul. 2004-86, which bars a trustee from refinancing the acquisition loan; refinancing before or after a 1031 covers the general timing principles.