CASH OUT – Using Zero Cash Flow DST’s & 1031 Exchanges as a Vehicle for Maximum Cash Proceeds

1031 Exchanges are a well-known and a highly covered topic for tax deferrals. Cash out refinances are one of the best ways to access built up equity reserves, without incurring a taxable event. Pairing the two together is nothing short of tax magic.

If you are contemplating selling a property and desire to maximize your flexible cash proceeds net of tax, you typically have three options.

#1. Cash Out and Pay Taxes… - You can “cash out”, pay capital gains tax of 22.25%, depreciation recapture taxed at ordinary income rates, plus state capital gains tax which are often be taxed at ordinary income rates (as high 12.3% for the top bracket in California.) For a business operator, if you are seeking to access cash from a sale, this is typically the worst option which could result in giving 40% and as high as 60% of the proceeds back to the state and federal government. This leaves you with roughly only 40-60% of your investment after paying tax. On a $10M all cash transaction, you could be left with a paltry $4M-6M…

#2. Execute a Traditional 1031 Exchange Followed by a Cash Out Refinance - You can execute a 1031 exchange by acquiring a like kind investment property, allowing you to defer capital gains and retain 100% of equity value (as long as you replace both the debt and equity.) These taxes don’t become due until the sale of that replacement property (if you fail to continue 1031 exchanging into perpetuity.) Again, if your goal is to maximize your cash raise, you will look to refinance after the 1031 exchange is complete, and might be able to achieve an LTV of 50-70% (assuming the income from the property will cover the debt service & market determined debt service coverage ratios.) On that same $10M example, you would retain $3-5M in equity and receive $5-7M cash out after the refinance. This is a good option to preserve the Tax shelter by deferring the capital gains and generating substantial cash to put to work.Procedurally, when you close on your downleg property you will have a stressful 45 Days to identify your replacement property and 6 months to close. After closing, you will seek bids to refinances for 30+ days, 30+ days to go through a lender underwriting process where you will be scrutinized for wanting to receive cash out proceeds which may limit a lenders willingness to stretch on the LTV, and finally after 60-90 days you will receive your cash to play with. All in all you should expect 6 months to a year from closing your down-leg sale of your relinquished property to receiving your proceeds.

#3. High Leverage, Credit Tenant Lease, Zero Cash Flow DST’s - Now here is the “tax magic” I was referring to earlier. This investment product is a lucrative product historically used by Billionaires as a way to maximize their flexible cash proceeds through a 1031 exchange. A Zero Cash Flow backed by a long term NNN lease guaranteed by a credit tenant generates in my opinion, the highest LTV possible due to a couple of the investment parameters:

1.) Zero Cash Flow – The Net Income= Debt Service producing no cash flow.

2.) Long Term Lease – Typically 20 Years as the Amortization of the loan must equal the lease term.

3.) Investment Grade Credit Tenant – Viewed as the ultimate guarantor by lenders, allowing lenders to underwrite extremely aggressive interest rate quotes on a fully amortizing loan.

4.) Low Interest Rates, High Loan to Value (LTV) – Most aggressive interest rates due to credit tenants allowing for very high LTV’s in the 85-90% of total value.

5.) Institutional Quality Assets – Large Amazon Warehouses, Massive Government Buildings, Corporate Headquarters, etc.. These assets are typically massive deal sizes in the multiple hundred million if not nearly Billion Dollar deals.

If your goal is to most efficiently pull out the most cash possible by selling a real estate asset, this strategy is unmatched. In that same $10M example, you would retain $1-1.5M in equity shares of an institutional quality asset and receive $8.5-9M in cash out refinance proceeds. Additionally, the acquisition & refinance process is exponentially more seamless than that of #2 above. After selling your relinquished property, you simply identify the ZCF DST on your 1031 ID Sheet and instruct the accommodator that you wish to close on this property. Since the DST already owns the asset, you can close immediately, shortening your acquisition period from 6 months to a matter of days.

After holding the asset for 30 days, you will receive an offer to refinance from the DST, notifying you that you have the option to cash out refinance up to the LTV amount of the deal which is typically 85%. Once you elect to proceed with the cash out refinance, you will receive your loan proceeds nearly immediately. On that same $10M example, you will retain $1M-1.5M equity in the institutional asset that should grow overtime as the rent increases and as the principle on the loan is paid down over time.

The best part is you will have $8.5M-9M in unrestricted “flexible” capital at your disposal. Since this is no longer part of the exchange, you don’t have to be concerned with like-kind investments and can use this capital to expand your business, donate to charity, or buy a yacht. Furthermore, since your basis of your relinquished property transfers to the 1031 property you acquired (the DST), you can earn more tax benefits on this $8.5M-9M of “new capital” through acquiring another asset and taking depreciation on that new asset with a new basis.

Another area this investment vehicle works extremely well is when exiting an asset that has a high LTV presumably because it has declined in value. For Example, say you refinanced with an interest only loan in 2021 at peak pricing and while the LTV made sense at the time, the sale price is much lower with the market having corrected leaving you only 20-30% equity after the sale. Normally, you wouldn’t be able to 1031 exchange without adding a substantial amount of cash as most lenders will not provide 70-80% LTV loans in today’s market. Even worse, depreciation recapture and capital gains could wipe out the remaining 20%-30% equity in the deal. With the Zero Cash Flow DST vehicle, you can successfully salvage your 1031 exchange and even receive some cash back at closing as opposed to having to come out of pocket and contribute cash to sell your property.

If you were looking for the largest amount of cash out proceeds available, I personally have not found a better option than zero cash flow deal packed by a credit tenant loan and credit at lease.

If you are interested in learning more, please contact Braden Crockett at braden@alphare.com.

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Disclaimer: We are not accountants, tax professionals or financial advisors. Nothing considered herein should be considered tax or investment advice. Speak with your CPA or Financial advisor to verify and confirm.