In 1988, Delaware enacted the Delaware Business Trust Act, which was later changed to The Delaware Statutory Trust (DST) Act in 2002. The DST is a statutory entity that is governed by Chapter 38, Part V, Title 12 of the annotated Delaware Code. The DST Act was passed to allow a lawfully recognized and flexible alternative business entity and is periodically amended to allow developments in business practices.
The DST Act opened the door for accredited investors to hold a fractional interest in real estate property with a relatively small investment. DST Investors can potentially benefit from an income tax shelter, non-recourse debt, 1031 “like-kind” exchange eligibility, and diversification.
DST Formation Requirements
Forming a DST requires a private trust agreement to be developed by all involved parties to make sure individual interests are protected. With an agreement, a Certificate of Trust can be acquired from the Delaware Division of Corporations. The trustee(s) must sign the required documents and submit the forms to the Division of Corporations with a $500 processing fee.
Generally, there are two types of participants in a DST entity:
- Trustee - The trustee holds the legal title to the assets in the trust but must follow the terms laid out in the private trust agreement regarding asset management.
- Beneficial owner - The beneficial owner holds ownership, and they must comply with the same terms from the trust agreement regarding their ability to manage, control, or use assets from the trust.
At least one trustee must be a resident of the State of Delaware and can be accomplished by naming a Delaware trust company or forming a Delaware corporation to act as trustee.
IRS Revenue Ruling 2004-86
In 2004, the IRS issued Revenue Ruling 2004-86 which stated that beneficial interests in a DST would qualify and be treated as replacement property for a 1031 exchange.
1031 eligibility allows investors to exchange into a DST with the opportunity to indefinitely defer capital gains taxes. A DST 1031 exchange also allows investors to participate without being the sole owner or manager of the property. DSTs have become a preferred vehicle for passive real estate investment.
DST Seven Deadly Sins
The IRS has placed restrictions on what a trustee can and cannot do in the management of a property. These rules are known as the Seven Deadly Sins.
- Once the offering is closed, the trustee cannot accept future DST equity contributions from new or existing investors.
- The trustee of the DST cannot renegotiate terms on the existing loan, nor can new funds be borrowed unless a loan default exists or is imminent due to tenant bankruptcy or insolvency.
- The trustee cannot reinvest the proceeds from the sale of the investment.
- The trustee can only make capital expenditures to the property for the following reasons: (a) normal maintenance and repairs to the property, (b) minor, non-structural capital improvements, and (c) those that are required by law.
- Any cash held between distribution dates can only be invested in short-term debt obligations.
- All cash, except for necessary reserves, must be distributed on a regular basis.
- The trustee cannot enter new leases or renegotiate leases unless there is tenant bankruptcy or insolvency.
Important DST Considerations
Although the Delaware Statutory Trust Act offers investors the benefits of a fractional interest in real estate, there’s potential risk that DST investors must be aware of. A possible safety net for DST investors is the ability to convert the DST into an LLC, allowing the trustee to raise new funds or refinance the DST’s property. Be advised of the possible tax consequences for investors.
If you’re considering investing in real estate through a DST, speak with your financial advisor and a tax professional to weigh the potential risks and benefits and ensure it aligns with your investment goals.