Geoff had a long and not very friendly divorce. In the process, he gave up most of his liquidity and part of his retirement account in order to pay attorney fees and part of the settlement to his ex. At the end of 2018, Geoff found himself still owing a lot of money. He had very little liquidity.
Geoff owned a few DSTs and looked into liquidating one of these to pay off the final bills. There was a problem, though: Geoff had purchased DSTs to avoid having to pay a lot of taxes. Selling one of them now would create a large tax bill.
Geoff needed to pay the debts off sooner rather than later, as making small annual payments was not an option. However, he was limited on what he could sell to get the creditors off his back. He had to keep his current residence to live in. He had a former residence that had been rented out for most of the prior ten years. This property looked like the best choice for Geoff to liquidate in order to pay off debts. However, he had owned this property for 30+ years, so selling it and taking the cash would cost him a lot of tax.
The property was worth about $1,500,000. If Geoff had had no debt on the property, life would have been simple. He could have sold it and taken the $250,000 in cash that he needed to pay off his divorce debts. We could have sheltered most of this money for him, and he would have ended up with very little tax on the transaction. Unfortunately, in the past few years, Geoff had been forced to borrow against the property. It now had a mortgage of approximately $480,000.
Geoff’s Rock and Hard Spot
Geoff needed to get rid of these debts: that was his “rock.” His “hard spot” was that taking that much cash out of the property would leave him with a tax bill in excess of $60,000. He didn’t have the $60,000 to pay.
From here, things went from bad to worse. The only way Geoff’s tax bill would get down to below $60,000 was if he reinvested his sale proceeds in properties where he could get some benefit from cost segregation and exchange expenses. Geoff needed to take money out of the exchange to pay taxes on top of the $250,000 he was already taking out. This meant he would need more boot to pay the tax on the money he was taking to pay the tax on the original boot. His cost segregation and exchange expenses benefits would therefore be reduced. Ultimately, he would need another $100,000 of cash.
Zero-Coupon DSTs to the Rescue
Boot can be sheltered if there is enough trade-up basis and if cost segregation is available. Trade-up basis comes from adding debt or from adding additional cash. Geoff didn’t have extra cash, so his answer was to buy a zero-coupon DST, with no cash flow and a high LTV, and get trade-up basis. In Geoff’s case, putting $171,000 into a zero-coupon DST gave him enough excess basis to get rid of most of the tax. He will still have some tax in California, but he has already had this tax withheld.