As you may well know, a Delaware Statutory Trust (DST) is a promising investment offering benefits like tax deferral and passive income. However, many risks are involved, including environmental issues that result in losses or destruction of the underlying assets. Repairs and remediations are necessary to ensure continued operations, but the nature of DSTs creates a problem over who is responsible for this risk and how involved the DST can actually be in the remediation efforts.
In this blog post, Realized 1031 goes in-depth about DST environment risks and remediation.
Environmental risk covers various hazards from the natural world, such as disasters and man-made accidents. Changing environmental regulations are also included under this category of risks.
In traditional real estate investments, environmental risk is usually handled by the investors, but this isn’t the case for DSTs, since the investor is merely a beneficial interest owner. It’s the DST that is liable to environmental risk. As such, the sponsor must take steps to mitigate this challenge. Environmental site assessments are often conducted as part of the sponsor’s due diligence before acquiring an asset.
A DST, as the legal owner of the underlying properties, is responsible for addressing environmental losses. However, those who are eligible for 1031 exchanges face one problem: Revenue Ruling 2004-86 prohibits DSTs from taking certain actions that would constitute “active management.” This restriction stems from the idea that DSTs are supposed to be passive in nature, and practices like major property improvements or new leasing activity can count as active involvement.
This reality creates a problematic situation. How can a DST protect its property and ensure continued cash flow if it cannot directly manage or improve the asset for 1031 exchange eligibility preservation?
There are a few ways the DST sponsor can get around these restrictions, ensuring compliance while preserving the value of the underlying assets.
Given the passive role of investors in DSTs, the best step to take is to choose a DST that has robust and compliant strategies for remediation. Examine the private placement memorandum (PPM) closely, checking information like the following.
Performing this due diligence helps you select DSTs with lower chances of suffering environmental damage, allowing you to protect your investment.
Environmental issues, while rare, can wreak havoc on DST investments. The DST is liable for addressing this risk, but the terms of 1031 exchanges limit its capabilities. As such, investors must choose DSTs with strategies that allow them to remediate damages while maintaining compliance. Careful sponsor due diligence remains an essential step for these investments.
Sources:
https://www.investopedia.com/terms/i/involuntary-conversion.asp
https://www.irs.gov/pub/irs-drop/rr-04-86.pdf
https://thecuriaregis.com/2023/06/environmental-risk-management/