Generally, commercial loans are nonrecourse to investors, meaning that no personal guarantee is required of the investor. However, there are exceptions with traditional real estate depending on the creditworthiness of the tenant, the creditworthiness of the investor, and the amount of leverage used on the property. With DST properties, the investor is not required to guarantee their portion of the debt. The loan is assigned to each specific investor according to their percentage interest in the trust. No personal guarantee is required, and the lender’s only recourse is against the DST property itself—effectively sheltering the investor’s personal assets from exposure to the debt risk should the proceeds from a foreclosure sale not fully satisfy the loan principal.
An advantage of a DST investment is that the lender does not need to qualify the investors because the investors are not on the title and the DST trustee is the one who signs the carve-out provisions. This allows for ease of transference in case of inheritance, divorce, or secondary market sales. This is not the case with a TIC, in which all investors are subject to lender approval.
In most nonrecourse commercial loans, the lender requires the investor to sign carve-out provisions within the debt instrument. These carve-outs are referred to as a “bad boy guarantee” or a recourse carve-out guarantee and ensure that the investor is liable both jointly and severally with the occurrence of bad acts, which includes fraud or other actions that directly damage the property or its financial capacity. This is also true for TIC investments; however, a significant advantage to the DST structure is that the trustee and not the DST investors sign the carve-out provisions. Thus, the DST investor loan is a nonrecourse loan, and the lender does not have access to the investor’s other assets in the case of default on the loan or recourse on bad acts.
Occasionally, investors might encounter DST offerings with high leverage loans for tax planning purposes. A high leverage DST offering has a loan-to-value rate of 84 percent and is designed to assist DST investors in replacing the higher leverage from relinquished properties to avoid a mortgage boot on the 1031 exchange. High leverage DST offerings are called “zeros” because they do not produce cash flow for the investor, and the lender sweeps the net cash flow to hyper-amortize the debt. While there is no monthly cash flow to the investor, these DSTs produce a 12 to 14 percent annual yield due to the amortization. In most cases, zeros are used within a portfolio of multiple DSTs to effectively blend the LTVs of multiple replacement 1031 DST properties and match the relinquished debt to avoid mortgage boot.
The tenant on the zero-cash-flow, highly leveraged DST has higher credit worthiness to satisfy the lender’s underwriting standards. Typical tenants include pharmacies such as Walgreens and CVS. The return on the zero DST is recognized once the property or properties are sold. These investments are considered a type of high yield savings account that helps to de-lever part of the portfolio in the short run. This is accomplished by investing the remaining equity from the higher leveraged DST into other DSTs with leverage below the relinquished debt level. In this way the entire portfolio is de-leveraged in the long-run due to hyper-amortization of the DSTs with higher debt.
A significant number of investors have owned their relinquished property for many years and have little or no remaining debt. In this case, it is worth considering increasing tax basis through investment in a higher leveraged property. If an investor assumes greater debt with the replacement property than they had with the relinquished property, the additional amount of debt is added to the tax basis of the investment. This additional tax basis depreciates over a new useful life on a straight-line basis and provides increased tax shelter due to a larger deduction for depreciation expenses. Please note that depreciation is an accounting concept and is allowed even if the property is appreciating in value. The additional depreciation shelters as much as 50 to 60 percent of the investor’s rental income cash flow from income taxation.