Zero cash flow deals are deals structured so the property’s NOI goes to service the debt from the lender, leaving nothing left for the owner.
Although this results in zero net income – a situation that most investors would assume you should avoid- there are actually several tax advantages to creating a zero cash flow deal, especially if you choose a zero cash flow triple net.
Advantages Of Zero Cash Flow Deal
Zero cash flow properties must meet several criteria in order to be considered a true zero cash flow deal. The property must be occupied by a tenant with a credit rating of at least BBB, and the length of the lease must be for a minimum of 20 years.
The properties that fit these criteria are triple net lease properties, which are known for offering investors a steady source of passive income with no management responsibilities. In addition, since zero cash flow deals can be done with as little as 13%-18% down and the length of the lease is longer than the time it takes to amortize the debt, the investor ends up owning the property before the lease ends. When the lease does end, the investor owns a property with good residual value and a secure cash flow.
The other advantage of cash flow deals is that they can be used in 1031 and 1033 exchanges as a like-kind property, which means investors can use them to defer capital gains taxes, particularly when selling highly leveraged properties.
Another instance where investors might choose to use a zero cash flow deal is when a LLC or partnership needs to offset their current income with a higher depreciable basis. In that case, investors simply buy the most highly leveraged depreciable basis.
And lastly, the buyer can set up a loan that matches the specific debt and equity requirements for their 1031 or 1033 trade, including the option of refinancing and cashing out part of the equity after the exchange is completed. Once this equity is withdrawn, it can be used for other cash flow assets with full depreciable basis outside of the exchange.
What To Watch Out For With Zero Cash Flow Deals
The main risk with zero cash flow deal is with what is termed as phantom income.”
This occurs when the rental income is equal to the payment to service the loan, which generally occurs as a natural result of paying down the principal and the resultant decrease in interest. When this happens the owner must then pay taxes on the principal part of the loan.
It’s best to consult with an experienced broker in this case since generally there are only two options for the investor facing “phantom income.” The owner can withdraw proceeds that they are expected to receive from the property (kind of a pay in advance), or the investor can choose to sell the property, using the money to pay off the loan and the pre-payment penalty.
Fortunately, even if the investor chooses the second option, they will still be able to enjoy a good profit and health return on their investment.