Distressed owners are entirely interested in burying their former basis into a 1031 exchange replacement property as a means to defer an otherwise crippling tax bill. Zero’s are typically priced at somewhere between 8%-10% of the debt load on the underlying property – making them a cost effective solution.
Foreclosed properties are deemed to have sold for the balance on the debt owed. This is the amount needed to be covered in a new 1031 transaction to defer your gain. In simple terms if you defaulted on a $10Mil loan, you’ll need to replace that property with a new $10Mil property. Generally speaking that would cost between $800K and $1Mil. Compared to your potential tax bill a zero transaction could produce a savings of close to 50%.
A person in the second group (highly leveraged sellers) is in a similar situation. Their property is sold, albeit in an orderly transaction, but ultimately because they borrowed so much relative to the sales price they walk away from closing with very little money. Sometimes not enough to pay the tax bill. Once again, the zero provides a low cost way to defer the tax consequences.
The third and probably smallest group consists of 1031 buyers looking to use a structure commonly found in zero’s called “Paydown-Readvance”.
The “paydown” part involves dedicating all equity from your old property to the transaction (this is still a 1031 fundamentally). After the deal closes you “readvance” or draw on the loan to the point where only the minimum required equity remains in the deal. This allows a 1031 buyer to walk away from the closing table with extra cash. The downside is that you are left with a 20 year investment you can’t refinance and a property that doesn’t produce cash flow.