A Sellers Guide to Zero Cash Flow Assets
(Section 467 Debt, Zero Cash Flow, ZCFs, Bondable Leases, Self-Amortizing Debt)
Ocean Block Capital Acquires Zero Cash Flow Assets
We have acquired 32 zero cash flow assets over the past thirty-six months. We are experts in underwriting and acquiring these complicated assets. See below for what you need to know to understand your zero cash flow property and call us if you’re interested in monetizing your locked equity in this asset class.
What is a Zero Cash Flow Asset?
A Zero Cash Flow investment property is a highly leveraged asset (up to 90% debt) backed by a long-term lease from an investment grade credit tenant. CVS Health, is an example of a tenant who has been signing zero cash flow leases with Section 467 debt structure for the past three decades.
In these 467 debt structure deals, CVS pays its monthly rent directly to the lender (e.g. Wells Fargo) leaving zero dollars to be distributed to the landlord; hence the term ‘Zero Cash Flow.’ This creates an interesting dynamic between the tenant, landlord and lender; as accountable income and interest is accrued to the landlord without a dollar ever entering his or her hands.
Complications – Principal & Interest
Section 467 debt allows the lender to distribute the principal & interest payments in unordinary ways while allowing the monthly rental payment to remain the same. Using CVS as an example, if CVS owes $200K in annual rent to a Landlord – it is common to see an interest write off of $190K while paying off $10K in principal in year-1 with the opposite occurring in year-22. Now, it is important to remember this is a zero cash flow asset.
The landlord is “paying” both the interest and principal without cash ever entering or leaving his or her hands. Thus, the investor can write off this interest and gain the principal on the asset. Generally, this makes Section 467 debt structure assets attractive to 1031 exchange investors with extraneous cash flows as they are able to take advantage of this significant tax write off.
Entering the second half of the loan, the principal begins to outweigh the interest. The IRS views principal exceeding interest as ‘income’ even though the investor never actually receives cash flow. This perceived ‘income’ is a phenomenon known as Phantom Income, income that cannot be seen but is being accrued.
The investor is responsible for paying taxes on this phantom income. A zero cash flow investor needs to be prepared to pay the IRS for phantom income or sell prior to the period where principal outweighs the interest, typically year 12.
Advantages and Harms
Acquiring a Section 467 debt structure asset carries with it many advantages and harms. The price point and interest write offs are attractive during the first decade of the loan. However, without proper planning it can cost an investor hundreds of thousands of dollars in phantom income.
When leveraged with other cash-flowing assets, zero cash flow deals can be an incredible addition many portfolios. If you have any questions concerning either your acquisition or disposition of a Section 467 debt zero cash flow asset, please feel free to contact us here.