Many modern investors find Delaware Statutory Trusts (DSTs) appealing because they offer tax-deferral benefits and diversification without the headaches of hands-on management. Beyond these well-known benefits, these investments also follow a bankruptcy-remote structure that helps protect investors from liabilities tied to sponsors and other investors.
Bankruptcy-remote structures serve as legal safeguards that prevent financial issues from spreading. How does this structure work? Realized 1031 goes in-depth to help you understand how liability is isolated.
In the context of investing, a “bankruptcy-remote” entity is one that has a structure that protects it from another party’s bankruptcy, especially in arrangements where assets are commingled or accessible to creditors of the bankrupt party. The primary mechanism is the creation of a single-purpose vehicle (SPV), a legal entity created for a single, well-defined, and narrow purpose. One example is holding the real estate asset in a DST.
In many cases, the DST itself is the SPV thanks to how it’s established as a separate legal entity under Delaware Law. Because of the isolation, the trust and its assets are insulated from claims made against the sponsor, master tenant, or investors.
The bankruptcy-remote structure of a DST protects investors from liability in the following ways.
1031 exchanges allow for capital gains tax deferral, which lets investors preserve their capital and avoid major tax hits. Without the protections of the bankruptcy-remote structure, the DST’s income could be lower than anticipated, as it pays for unplanned debts. In extreme cases, the trust may no longer stay operational due to the lack of funds. Ultimately, these issues could result in the recharacterization of the DST’s interest, removing its tax-deferred status.
Thankfully, the built-in isolation of DSTs helps investors avoid these issues and preserve the DST's eligibility. The bankruptcy-remote provisions act as a critical safeguard against the loss of the investment’s tax-advantaged status.
DSTs follow a bankruptcy-remote structure because they’re established as SPVs. This added protection from the liability of sponsors and other affiliates adds assurance for investors who want to protect their assets. This benefit is particularly appealing to 1031 exchange investors, as it helps protect capital from others’ liabilities and preserve their tax-deferred status. Due diligence is still essential. You should review the DST trust agreement, loan documents, and offering memorandum to understand how the bankruptcy-remote features are implemented in the specific offerings.
Sources:
https://www.investopedia.com/financial-edge/0110/10-things-to-know-about-1031-exchanges.aspx