In short
A zero cash flow DST pays no monthly income because the rent services a large loan. Why that structure replaces debt, why refinance cash is not boot, and the risks.
A zero cash flow DST is a Delaware Statutory Trust that owns a property leased long term to an investment-grade tenant and carries a large loan against it. The rent goes to the lender, so you receive no monthly distributions. In return the structure does two things a conventional DST cannot: it satisfies a large debt-replacement requirement with a small amount of equity, and, as our cash out DST page describes, it can later be refinanced to return most of your exchange value as cash. Here is the plain-words version of how and why.
What “zero cash flow” means
The firm’s product page describes the structure this way: a zero coupon DST built around triple-net leased property with an investment-grade tenant on a long lease, where “all income generated from operations goes toward servicing the debt and amortizing the loan.” Investors “do not receive current income distributions” but keep the potential for appreciation and a payout on sale, and the loan is non-recourse, so only invested capital is at risk. The general legal framework is the one in Rev. Rul. 2004-86: the trustee’s role is limited to holding title, collecting rent, paying expenses and debt, and distributing what is left. In a zero cash flow trust, what is left each month is zero by design. The product detail is at zero cash flow DSTs explained.
Why the loan is the point
When you sell a mortgaged property, the lender is paid from your proceeds. Reg. section 1.1031(d)-2 treats a liability the other party takes over or pays off as “money received by the taxpayer upon the exchange,” and allows debt you take on with the replacement to offset it. If the replacement carries less debt than you shed, the difference is boot, taxable unless covered with cash.
A property in a highly leveraged DST comes with its loan already attached, and your share of that loan counts toward the debt you must replace (does a DST loan count as replacement debt). Because the loan is large relative to the equity, a small slice of your proceeds covers a large debt requirement. That frees the rest of the equity for property you choose for income.
A hypothetical. You sell for $1,000,000, pay off a $600,000 mortgage, and have $400,000 of net proceeds at the intermediary. To defer everything you must acquire $1,000,000 of replacement value and either take on $600,000 of debt or add $600,000 of cash.
Suppose a zero cash flow DST is financed at 85 percent of value. A $150,000 subscription represents $1,000,000 of property with $850,000 of allocated debt. On its own that one interest satisfies both the value test and the debt test. Your remaining $250,000 of proceeds can go into income-producing DSTs or a direct title security, and none of it is boot, because it is still reinvested in like-kind property. The 85 percent figure is illustrative; every trust’s leverage is set in its offering documents. Run your own numbers with your CPA.
Why refinance cash is not boot
The second use is liquidity. The product page describes a later refinancing, after which “you can receive 80–90% of your exchange value as cash.” The tax reason that cash is not boot is older than DSTs. In Commissioner v. Tufts, the Supreme Court restated the rule that “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.” Borrowing against property you own is not a sale, so a loan taken after the exchange closes does not change the exchange. How and when a particular trust arranges that refinancing, and what it costs, is set out in its offering documents; our page on how much cash a zero cash flow DST can return goes further.
The tax that arrives without cash
The trade-off is phantom income. Rent is gross income to the owners whether or not it is distributed (Publication 527: “you must include in your gross income all amounts you receive as rent”). Interest on the loan is deductible under section 163(a), and depreciation is deductible, but there is no deduction for repaying principal. As a loan amortizes, more of each rent payment goes to principal and less to interest, so taxable income from the trust rises over time while cash to you stays at zero. Your share of the depreciation is what offsets it, and because you carried a low basis into the exchange, that shield is limited. Our page on phantom income in a zero cash flow DST works through a year-by-year schedule.
Risks in plain words
- One tenant, one lease. The trust’s income depends on a single tenant paying for the full term. The trustee cannot re-lease the property except on the tenant’s bankruptcy or insolvency under the ruling’s restrictions.
- Leverage cuts both ways. A small change in value at sale is a large change in your equity.
- No income to live on. This is a debt-replacement and liquidity tool, not an income replacement. A traditional DST is the income product; see traditional DST versus cash out DST.
- Illiquidity until sale or refinance. There is no market for the interests, and the loan’s maturity sets the calendar; see what happens at the end of the loan.
What to do now
- Compute your debt-replacement number: the mortgage paid off at closing less any cash you intend to add.
- Decide how much of your proceeds you want working for income and how much can sit in a zero cash flow interest doing the debt job.
- Read the offering’s loan terms, lease term and refinancing provisions before day 45, and have your CPA model the phantom income. Then start your exchange plan.
