The Limitations of Delaware Statutory Trusts in 1031 Exchanges

The Limitations of Delaware Statutory Trusts in 1031 Exchanges
Posted by on Apr 27, 2016

Delaware Statutory Trust Tax Treatment & Rev Rul 2004-86 Cover Photo

The Delaware Statutory Trust (DST) is a popular investment option for a 1031 exchange. For many investors, DST Replacement Property Interests offer the opportunity to exchange into properties that would otherwise be beyond their reach—and enjoy a predictable income stream without any landlord obligations.

The appeal of DST 1031 investments is that they allow multiple investors to purchase ownership interests in institutional-quality properties like apartment complexes, office towers, and retail centers. However, investors considering a DST investment should be aware of certain limitations.

In 2004, the IRS issued Revenue Ruling 2004-86, which held that beneficial interests in a DST (i.e., the 1031 exchange investors) would be treated as replacement property for a 1031 exchange—subject to seven key restrictions (this announcement built on Revenue Ruling 2002-22, which was released, as it happens, in 2002, and is also referred to as "rev proc 2002-22"). Arnie Harrison, the attorney that pioneered the use of DSTs for exchanges, referred to the Revenue Ruling 2004-86 restrictions as the “Seven Deadly Sins”.

As with any type of trust, a trustee is responsible for administering a DST. In this ruling, the IRS made it clear that the DST must be passive holder of real estate, and placed significant prohibitions on the trustee of the DST. Following are the IRS requirements, or the “Seven Deadly Sins.”

  1. Once the initial offering is closed, there can be no future contributions to the DST by either current or new investors.
    • Unlike partnerships, limited liability companies (LLC) or real estate investment trusts (REITs), the DST cannot raise additional capital. As a result, future capital expenditures need to be planned well in advance.

  2. The Trustee of the DST cannot renegotiate the terms of existing loans, nor can it borrow new funds from any party—unless a loan default exists or is imminent, due to a tenant bankruptcy or insolvency.
    • The mortgage on a property is a key consideration when evaluating a DST investment because upon maturity of the loan, the DST cannot refinance the property. For this reason, DST properties are sold well in advance of the mortgage maturity, and the property sale proceeds are distributed to the DST investors. They, in turn, are then able to do a subsequent 1031 exchange if they choose to do so.

  3. The Trustee of the DST cannot reinvest the real estate proceeds from a sale.
    1. When a DST sells a property it owns, the property sale proceeds are distributed to the DST investors, who are then able to do a subsequent 1031 exchange—if they choose to do so.

  4. Any reserves or cash held between distribution dates can only be invested in short-term debt obligations.
    • Because a DST cannot accept additional equity contributions (see #1 above), the trustee of a DST will often hold sizeable reserves to cover future capital expenditures and other expenses. This restriction precludes trustees from using these reserve funds in a speculative manner.

  5. All cash, other than the necessary reserves, must be distributed on a regular basis.
    • When the DST receives cash from its properties, it must be distributed to the DST investors in a timely fashion (usually quarterly).

  6. The Trustee of the DST is limited to making capital expenditures, with respect to the property, to those for: (a) normal repair and maintenance (b) minor non-structural capital improvements, and (c) those required by law.
    • It’s important to realize that making major improvements to a property is prohibited, and for this reason, DST properties tend to be newer assets.

  7. The trustee of the DST cannot enter into new leases or renegotiate the current leases, unless there is a tenant bankruptcy or insolvency.
    • This one tends to be surprising for most people. How can the DST operate an income-producing real estate asset without the ability to enter into leases? The answer is the DST enters into a long-term lease contract with an affiliated entity to operate a property at the time it is acquired; this is known as a master lease.

The DST Safety Net

There is a safety net if these limitations place a DST at risk. The state of Delaware permits a DST to convert into an LLC (known as a “Springing LLC”), which allows the trustee to then raise new funds and/or refinance the DST’s property. However, this may have tax consequences for the DST’s investors, and is put in place only if necessary.

DST investments are a welcome option for many 1031 exchange investors. But an investor contemplating purchasing DST interests needs to carefully read the offering material and independently develop an understanding of how these limitations may affect their investment.

With nearly 60 years of collective experience and $5.0 billion of real estate transactions behind us, the Realized team has the expertise and the tools to assist in understanding the risks and returns of investments. Visit our Marketplace to view a variety of tax-efficient, 1031-qualified real estate investment opportunities.

 


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