Investing in a Delaware Statutory Trust (DST) allows you to access income from the underlying properties. Keep in mind, though, that sponsors acquired these assets through financing. The type of debt structure can affect whether or not you’re exposed to DST investment loan liability on a personal level.
Sponsors typically follow two types of debt structure: non-recourse and recourse loans. To help protect yourself from personal liability, it’s important to understand the key difference between these two. Today, Realized 1031 has shared an article on recourse vs non-recourse debt in DSTs to help you gain in-depth insight. Keep reading to learn more.
The Difference Between Non-Recourse vs. Recourse Loans
Lenders, especially those who focus on commercial real estate, often offer either non-recourse or recourse loans. Each one has unique characteristics and features that make it suitable for certain arrangements.
Recourse Loans
A recourse loan allows a lender to recoup its investment from the borrower’s personal assets if the latter is unable to pay their dues. This structure is a form of secured financing where the borrower remains personally liable for repayment. For those who’ve taken out personal bank loans before, the recourse loan is probably the arrangement you followed.
Non-Recourse Loans
Meanwhile, a non-recourse loan limits where a lender can recover to only the collateral itself. In many cases, the collateral is the property acquired by the DST sponsor. If the property fails to perform, and the DST cannot repay its debt obligations, then the lender can seize the underlying asset. However, if the asset isn’t enough to cover the dues, the creditor cannot go after the personal assets of the investors involved in the DST.
This distinction is important because DSTs usually follow the latter structure. Recourse loans tie the investor’s personal wealth to the investment, while non-recourse loans don’t. This feature makes non-recourse financing a far more attractive option to investors.
Non-Recourse Loan DST: Why Sponsors Typically Follow It
The security that a non-recourse loan provides to investors is one of the reasons why it’s the preferred option for DSTs. However, there is one more critical rationale for why sponsors follow this structure: 1031 exchange compliance.
DSTs are eligible for the like-kind exchange because of Revenue Ruling 2004-86. However, the trust must follow a few rules to ensure continued compliance and maintain the tax-deferred status.
Primarily, the DST must maintain a passive nature. If one investor leverages personal assets to pay the lender, then this implies that the investor is financially responsible for the DST and constitutes active involvement. As a result, the DST can become an active business entity and lose its tax-deferral status.
Do DSTs With Recourse Loans Exist?
Yes, but they are rare. Not all DSTs are made for 1031 exchanges. Some are established for pure cash investment, and they are typically small and specialized investments. These DSTs often arise when the property or borrower profile doesn’t meet the typical lender criteria for non-recourse financing.
For example, if a DST invests in a higher-risk asset class or if the loan amount exceeds typical lending limits, a lender may require partial or full recourse terms to mitigate their risk.
In such arrangements, investors are more exposed to recourse loan risks in DST investments. You may be personally liable if the DST defaults, especially if the lender seeks recovery beyond the value of the asset. This risk directly contradicts a typical DST’s benefits, which are limited liability and truly passive ownership. As such, most investors prefer DSTs that are eligible for 1031 exchanges for these added protections.
Why DSTs With Non-Recourse Loans Are the Preferred Option
In summary, these are the reasons why a DST typically uses non-recourse loans.
- 1031 Exchange Compliance: A non-recourse debt structure allows DSTs to maintain their tax-deferral status.
- Investor Protection: Non-recourse debt ensures that, even if the DST defaults, the lender cannot come after the personal assets of beneficial interest owners.
- Lender Approval: Creditors don’t typically offer non-recourse loans unless they are certain that the underlying properties can perform well to pay the loan and interest. This fact adds one more level of confidence for investors, as they can be more certain that the DST can deliver on its projected income.
Wrapping Up: Delaware Statutory Trust Financing Non-Recourse vs Recourse
DSTs can either have a non-recourse or recourse debt structure. The first type is often the preferred option since it follows 1031 exchange rules and protects investors from personal liability. DSTs with recourse loans exist but are rare, and they often carry risk that may deter investors. For those who are entering a DST through a 1031 exchange, those with non-recourse are the better option.
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