When 3.5% Cash Flow is More Attractive Than 5% Cash Flow – Understanding Tax Equivalent Yield

Author: Christina Nielson
Corcapa 1031 Advisors
Date: November 30, 2022

When 3.5% Cash Flow is More Attractive Than 5% Cash Flow – Understanding Tax Equivalent Yield

Why should an investor 1031 exchange into a 3.5% projected cash flow multifamily DST instead of the seemingly more attractive 5% net lease DST featuring a FedEx, Tractor Supply, Dollar General, Burger King, or CVS Pharmacy? The answer comes down to the benefits of real estate depreciation and tax equivalent yield.

Moderately leveraged multifamily provides some of the best shelter to positive real estate cash flow a 1031 exchange investor can find, and the leverage is non-recourse – meaning the bank cannot require the investor to satisfy an unpaid mortgage balance.

For example, an investor exchanges their $1M into a 50% LTV DST, aka $1M equity with $1M debt, for a total purchase price of $2M. If 90% of the DST property is the depreciable building, this may add $900k the investor’s depreciable basis assuming they have no additional carry-forward basis. With the 27.5yr accelerated depreciation schedule of multifamily, this means that this investor can shelter 1/27.5^th of $900k, or $32,727 per year.

If this multifamily DST is paying 3.5% cash flow ($35,000), then the taxable income is the difference between the income ($35,000) and the depreciation ($32,727) which equals $2,273. So, 35% tax on $2,273 is approximately $796, and net income after taxes is 3.42% or $34,204.

In contrast, let’s assume the same investor with $0 basis has their $1M to exchange and invests into a NNN, all-cash DST paying 5% or $50,000. If the investor pays 35% income tax, then post-tax cash flow is at 3.25% or $32,500.

This illustrates that the 3.5% multifamily cash flow nets more in your pocket post tax than the 5% net lease. To calculate the tax equivalent yield 3.42/.65 (1 – tax rate) = 5.26%. This means that the NNN property would have to cash flow in this scenario at 5.26% just to break even after taxes. This again, assumes that the investor is $0 basis and has taken on no new debt.

Net leases are often long-term and contractual, which may present a challenge in an inflationary market as your signed lease may not the future market rents. Moderately leveraged multifamily DSTs may be considered the “net lease” of the fractional real estate world as ownership is completely passive, there are no management responsibilities, and the loans are completely non-recourse. This way, you get the best of both worlds: the passive ownership of real estate (like a net lease investment) plus the accelerated depreciation schedule of residential property, and no single tenant risk. We encourage you to review full offering memorandums and discuss this with your DST representative.

This information is for educational purposes only and does not constitute an offer or solicitation to purchase securities. Formal inquiries must refer to the Private Placement Memorandum for specific and detailed information on all risk factors. For use only between the intended recipients and their tax and legal counsel. You are strongly advised to consult with your own legal and accounting professionals before making any investment decisions. 

At Corcapa 1031 Advisors, we provide guidance and help investors find the best investments in the marketplace. Contact us today for a review of your real estate portfolio. – (949) 722-1031.

Securities offered through DAI Securities, LLC, Member FINRA/SIPC