Tax Problems with ‘Zero’ Solutions

By Richard T. Murphy, Calkain Asset Management

A zero to some degree is exactly what it sounds like: an investment that produces zero cash flow. On its face, that doesn't sound like much of an investment opportunity. Once you understand the investment, its benefits become readily apparent -- but there can also be tax issues.

Deutsche Bank says two-thirds of loans maturing from now through 2018 cannot be refinanced. It also estimates at least two-thirds of CMBS loans maturing between now and 2018 will unlikely qualify for refinancing at maturity without significant equity infusions from borrowers. The numbers we are talking about here are in the trillions of dollars.

If only a fraction of those loans defaulted, we would see a sizeable market for zero transactions.

A zero to some degree is exactly what it sounds like: an investment that produces zero cash flow. On its face, that doesn’t sound like much of an investment opportunity. However, once you understand the investment, its benefits become readily apparent.

The zero cash flow described here is after debt service cash flow. Said differently, it’s a property with such a high loan to value note on it that its debt service coverage ratio equals one.

They are assembled from properties with leases that have investment grade tenants (low default risk) whereby the leases and the loans are tied together in such a fashion that the debt service payments are exactly equal to the rent and vice versa. It should be noted that zeros only work with non-recourse loans. CMBS loans are perfect examples of loans that could create scenarios where zeros are viable.

Here are some examples which I’ve encountered:

• A client was highly leveraged and forced to sell a property. At closing he lacked the funds to pay his taxes. A zero transaction made sense for him due partially to his age. The maturity of the zero was around his retirement age; giving him a valuable asset he could reposition or sell. It could aid in either estate planning or cashflow for his retirement; eventually passing it on to his heirs.

• A client wanted max proceeds from the sale of a property he was conducting but wanted to do avoid the taxes. Using a 1031 Exchange with “Paydown-Readvance”, he was able to pull as much equity from the replacement property as possible. This allowed him to use the loan proceeds for higher returning projects.

Essentially, zero cashflow investments often make solid standalone replacement properties for tax-driven investors; however, when strategically situated the investments can also provide substantial leverage as one replacement property and allow an investor to invest in more traditional investments as complementary replacement assets.