1031 Exchange Process Made Easy

By David Clary, Senior Director, Stan Johnson Co.

Completing a 1031 tax-deferred exchange in today’s market is easy, right? Are you seeing lots of replacement options out there?

Unfortunately, many net lease investors are not finding this to be the case. The cycle is this: the abundance of buyer capital creates liquidity, which leads to a high volume of sale transactions, which creates capital gains for the sellers who then enter the market as 1031 buyers. Yet the 1031 exchange process can be full of pitfalls. The time in which the investor has to gain control of, identify and close a replacement property runs quickly. The flood of competing buyers only amplifies the problem. All the while, cap rates are compressed to levels that for some investors are not attractive long-term.

One solution for the weary 1031 buyer is the purchase of a zero cash flow (ZCF) structured property.  A “zero”, as it is sometimes called, is a highly-leveraged property with a long-term, bond-quality lease backed by an investment-grade credit tenant. The term “zero cash flow” refers to the fact that all of the property’s net operating income during the primary lease term goes to service the underlying loan, and there is no cash remaining for distribution to the owner.

So why in the world would this be attractive?  As a result of the lender monetizing the entire stream of cash flow, the financing typically amounts to a loan-to-value in the range of 85 to 90 percent.  The high leverage provides the 1031 investor an opportunity to purchase a replacement property for the least amount of equity possible. And because the lender has underwritten the strength of the investment grade tenant, the loan is non-recourse to the borrower and easily assumable.
A particularly attractive feature in the loan is the “paydown-readvance” option, which allows the 1031 buyer to size the balance to match the debt and equity ratios of the exchange.  Once the property is purchased and the exchange is completed, the loan then provides the owner an option to refinance a substantial portion of equity.  The options are exercised within the existing loan documents, and there is no renegotiation of terms with the lender.  The refinance is a non-taxable event to the owner much like a new first mortgage financing, and the proceeds can then be deployed to cash-flowing assets outside the time restrictions imposed by 1031.  These newly acquired assets now provide the investor the benefit of full depreciation, something otherwise not available with assets purchased within the exchange process.

An important point for a prospective ZCF buyer to realize is there is an active market for the resale of these properties.  It is not uncommon for a 1031 buyer to “park” equity in a zero, sell it a short time later, and place the equity in a longer-term asset.  Who is the subsequent buyer?  Most times it is another 1031 investor with the same motivations as the initial buyer.  Eventually as the lease and loan mature, the property appeals to a new type of buyer who is not exchange motivated but rather seeks shorter-term residual value once the loan expires.

Have you run out of replacement options for your 1031 exchange?  Is all hope lost?  The answer is maybe not.  For some, a zero cash flow structured property is the solution.