Revenue Ruling 2004-86: What You Need To Know

If you’re investing in a DST via a 1031 exchange, you’ll benefit by having knowledge of Revenue Ruling 2004-86. The cornerstone ruling allowed 1031 exchanges into DSTs (Delaware Statutory Trusts) while solving the problem of using TICs (tenant-in-common) as a 1031 exchange vehicle. In fact, TICs have faded in favor of DSTs when doing a 1031 exchange. Read on to learn more important details about this ruling. 

How Ruling 2004-86 Effects DSTs

Revenue Ruling 2004-86, which went into effect on July 20, 2004, allowed property owners to 1031 exchange real property for undivided fractional interest in real property. The result is an investment in a DST and deferral of capital gains. All 1031 exchange rules must be followed for the deferment of gains to be a success. The ruling meant that DSTs holding real property were fixed investment trusts. 

Before Ruling 2004-86, investors utilized TICs via Rev. Proc. 2002-22. This ruling let investors 1031 exchange real property into an undivided interest in real property.

Ruling 2004-86 also classified DSTs as an investment trust rather than a business entity for federal income tax purposes. The following are some restrictions for this classification to hold. 

• The trustee can not vary the investments of the settlor. This basically means that once the DST is established and its investments completed (i.e., the DST is closed), it cannot change those investments. This is why it is called a fixed investment trust.
• The DST cannot take on new capital once it is closed. Existing investors also cannot contribute more capital. Their initial investment is their final investment.
• Properties in a DST can not be replaced with other properties. Meaning that one property cannot be sold so that another may be acquired.
• Leases cannot be renegotiated, and lessees cannot be replaced (unless the lessee goes bankrupt or becomes insolvent).
• Except for expense reserves, the trust must distribute all cash. If any cash remains, it must be invested in short-term investments.
• Proceeds from the sale of a property cannot be reinvested.
• Once a loan has been taken out, it cannot be replaced or refinanced. However, some limited exceptions apply, such as negotiating to avoid foreclosure. The loan will remain with the DST for the investment cycle.
• Only minor/non-structural modifications can be made to properties. 

Do investors executing a 1031 exchange into a DST need to memorize the above? No, but they should be familiar with this ruling and its caveats. Awareness of the ruling’s restrictions is another bit of risk mitigation knowledge that investors can add to their toolbox.