Calkain Swaps Tax Debt for Zero Cash Flow Assets in 1031

RESTON, VA-Losing a tenant in a single net lease property is tough. Losing said tenant during the worst recession in memory and not being able to replace it, is tougher. Hardest of all? That tenant loss eventually results in a foreclosure, which leads to a looming tax bill thanks to the loan associated with the property.

Calkain Cos. recently structured a $23 million zero cash flow transaction that mitigated this event for its client--the owner of the original property, which was located in a southwest market. The company could not provide identifying details due to client confidentiality but it did walk GlobeSt.com through the complex transaction.

Essentially, the client, a large family LLC, was able to orchestrate a 1031 exchange in which the foreclosed property was replaced by two properties, one in the northeast and one in the southeast that had CVS as a long-term client. “The sum of those two properties approximated the value of the loan on the southwest property,” managing director Jerry Burg tells GlobeSt.com. For the investor, the deal was golden, according to Andrew Fallon, an associate with the firm. “It allowed it to put off paying taxes from the foreclosure, live for another day and stay invested in real estate,” Fallon says, “which is an asset class it feels very comfortable with.”

In brief, the deal was structured along these lines: as a result of the foreclosure, the LLC had a debt obligation of approximately $22 million that needed to be replaced with the purchase of new assets. The LLC had enough liquidity to secure the 10% equity necessary to purchase the two zero-cash flow CVS properties, or zeroes as they are also called, thus allowing it to complete a 1031 tax deferred exchange.

Zeroes are highly leveraged properties, Burg explains, leased to investment grade tenants. Rental income from a zero is entirely allocated toward the servicing of the property’s debt, thus producing “zero cash flow” for the property owner. When used in a Section 1031 tax deferred exchange, as it was in this deal, a zero means the property owner is able to defer the taxes resulting from the transfer of a relinquished property with the smallest amount of equity needed to close the transaction. 

“The structure itself is simple,” Burg says. “It is just a 1031. What was complicated was getting all the parties involved and on the same page, including the special servicer.” Also, all the necessary pieces must be in place for such a structure to work, he adds, such as the availability of CVS-occupied properties. “Ten percent equity is a very low requirement and it was possible in this case because the lender was basing the loan on the creditworthiness of CVS, which signed a 25-year plus lease in the locations,” he says.

For borrowers that find themselves unable to work out an underwater loan with a lender, this is a good alternative, he says. “I think it would be used more often if more attorneys were aware of it,” he says.