Delaware Statutory Trusts (DSTs) source their income from the performance of the underlying properties. As such, the monthly income you earn has a direct relationship to the profitability of the real estate assets. What happens, then, if the property suffers damage or any other issue that may disrupt operations and cash flow?
DSTs can still conduct capital expenditures and repairs as part of 1031 exchange property maintenance, but the question of who can do it and where funds can come from can be complex. Realized 1031 is here to help you gain perspective. Keep reading to learn more.
What Are Capital Expenditures vs Repairs?
In any real estate asset, there are two major categories of property expenses: repairs and capital expenditures (CapEx).
Repairs
This category refers to the routine expenses associated with maintenance and minor property damage. These costs are necessary to keep the property in working order and ensure tenant satisfaction and safety. The following expenses fall under this category:
- Fixing broken doors
- Repainting small sections, like hallways or vandalized walls
- Patching roof leaks
- Replacing worn-out HVAC components
To be considered a repair, these fixes must only help maintain the current value and condition of the property.
Capital Expenditures
On the other hand, capital expenditures are significant investments that improve the functionality, lifespan, and value of the asset. These include roof replacements, installation of renewable energy sources, renovating tenant spaces, and room additions. CapEx typically increases property performance, extends useful life, or drives tenant retention and rental growth.
That definition is for general real estate investments. DSTs are a bit different, especially with the rules set by Revenue Ruling 2004-86 for 1031 exchange eligibility. Capital expenditures that improve the value of the property are prohibited in order to maintain the passive nature of the investment. Instead, CapEx is only allowed for major repairs to maintain the functionality of the structure or for legally mandated updates.
Who Is Authorized To Conduct DST Capital Expenditures and Repairs?
Another complex aspect of DSTs is the limitation on investors and sponsors. To maintain the passive nature of the DST, beneficial interest holders cannot have any operational control. In other words, investors have no say on matters like capital expenditures.
Sponsors are also prohibited from handling daily or routine repairs. For capital expenditures, the details are more intricate. The sponsor or trustee serves as the ultimate authority for these major expenses, and their responsibility is to give the go-ahead to the property manager or master tenant to handle the capital expenditure. Plus, the sponsor must maintain documentation that the CapEx was strictly done to follow new laws, like updated zoning regulations or ADA-compliance requirements.
Only the master tenant or property manager has the authority to actually conduct capital expenditures. They are also responsible for routine repairs and maintenance work. Their involvement creates a buffer between the sponsor and the properties, preventing material participation.
DST Expense Management: Sources of Funds
Repairs and real estate improvements in DSTs can be expensive. Since DSTs are prohibited from raising capital once the initial offering is closed, funding these property-related expenses must be handled with a strategic approach.
Primarily, DSTs have capital reserves that are either taken from the initial investments or gradually from the income of the property. The reserves are used to cover repairs and capital expenditures. If this isn’t enough, then the DST will appropriate funds from the rental income of the properties to cover the remaining expenses.
Why Understanding Delaware Statutory Trust Repairs and Expenditures Is Crucial for Investors
As a beneficial interest holder, you’re not involved in the property-level activities of the DST, including repairs and major expenditures. However, it is necessary for you to understand how these expenses are funded because they directly affect your income.
For example, major capital expenditures can source funds from monthly rental payments. This reduces the net operating income, which also lowers your overall earnings. When you’re aware of the specific IRS limitations on capital expenditures and the priority of reserve funding, you can better evaluate the risk profile of the DST offering and its long-term cash flow sustainability.
Wrapping Up: Basics of DST Capital Expenditures and Repairs
DSTs can incur capital expenditures and repair costs just like any real estate investment. However, the treatment of these expenses is different because of the trust’s structure. Only the master tenant or property manager can execute these fixes or major investments, and capital expenditures can only be applied when new laws require it or if the property suffers major damage. For investors, knowing how these costs are managed and where funds are sourced is critical in due diligence. This understanding helps ensure that you only choose DSTs with strategies that can address these expenses while maintaining long-term value in the investment.
Sources:
https://mf.freddiemac.com/docs/multifamily_legal_fyi_delaware_statutory_trust_august_2014.pdf
