The main driver of success for a Delaware Statutory Trust (DST) investment is the performance of the underlying assets. As such, streamlined and optimized property operations are necessary to ensure that cash flow remains stable and consistent. Given the passive nature of DSTs and restrictions imposed by the IRS, the lines become blurred between what’s restricted and what’s allowed for both investors and sponsors.
This insightful guide goes in-depth about the exact operating restrictions in a DST, and to whom these restrictions are imposed. Keep reading to learn more and help ensure your 1031 exchange is compliant.
IRS Guidelines for Delaware Statutory Trusts: A Look at Revenue Ruling 2004-86
DSTs qualify for 1031 exchanges because of Revenue Ruling 2004-86. This law created the structure and restrictions that allowed the trusts to become eligible for tax-deferral benefits. Under this revenue ruling, DSTs are not allowed to renegotiate leases, refinance debt, raise capital, or conduct various other processes once the initial offering period is closed.
All these rules are made to ensure that DST remains a passive investment. As a consequence, investors or beneficial interest holders are automatically prohibited from any direct role in the DST. Restrictions can be more confusing for sponsors, who still have some degree of control over the properties, but at a high level of oversight.
DST Operating Restrictions for Sponsors
The DST sponsor has the most active role during the formation of the DST, handling the structure of the trust, acquisition of assets, and marketing of the DST offers. After the offering closes, its role evolves due to operating restrictions. They focus more on high-level oversight to restrict “material participation,” which constitutes active management. The sponsor can only perform the following tasks:
- Approving major operational decisions like capital renovations or repairs
- Overseeing financial reporting
- Managing investor communications
- Maintaining compliance with IRS regulations
Who handles day-to-day operations, then? Because of the IRS restrictions, DST sponsors must engage with property managers to handle daily administration and management.
How Property Managers Facilitate Compliance with DST Management Rules
Property managers are professional teams that go into contract with the sponsor to handle the more nitty-gritty aspects of the property management. They create a buffer between the sponsor and the tenants, which helps maintain 1031 exchange compliance for the DST.
While the details differ from one DST to another, property managers generally handle the following daily tasks:
- Property Operation and Maintenance: The property manager handles repairs, routine maintenance, security, and other aspects of operations for the underlying assets.
- Tenant Management and Relations: Instead of directly engaging with the DST sponsor, tenants work with the property manager to address concerns or ensure streamlined move-ins or move-outs. Since sponsors are not allowed to renegotiate leases with tenants, the property manager steps in to handle lease renewals, renegotiations, and other related processes. They can even take on the role of master tenant that subleases the property or units to tenants.
- Financial Management: Most importantly, the property managers handle financial matters like rent collection, operating expenses, and cash reserve management. They also prepare the financial reports to be reviewed by the sponsor.
Considerations for Investors
Given the role of property managers in handling daily management and ensuring compliance with operational restrictions, they play a crucial role in the performance of the DST and the success of the investment. Poor property management can severely erode the cash flow and value of even a high-quality property. As such, it becomes critical to also evaluate the property managers the sponsor works with.
Assess their experience and track record from previous DST investments. Check their fees and costs so that you can set expectations for the distributed income. For a more thorough vetting process, you can also check their performance and expertise on the local market or sector in which the DST’s underlying property belongs. Information about the property manager should be available in the offering memorandum.
Wrapping Up: Delaware Statutory Trust Regulations for Property Operations
Even though investors are, by default, not involved in any aspect of operation in DSTs, it’s still crucial to understand the restrictions mandated by the IRS. This knowledge helps with due diligence, especially when vetting sponsors and property managers, who will be the parties that handle the operation of the DST. Choosing professionals with proven experience and a positive track record helps ensure the preservation of your tax-deferred status and brings you closer to investment success.
