Delaware Statutory Trusts (DSTs) became eligible for 1031 exchanges under Revenue Ruling 2004-86, which outlined the structure of qualified DSTs. The decree also mandated prohibited activities that would disqualify the DST from tax-deferral benefits. These so-called “seven deadly sins” are mostly a concern for DST sponsors, but knowing them as an investor helps you evaluate the compliance and long-term stability of the DST investment. Realized 1031 goes in-depth about these prohibited activities below.
1. No Additional Equity
DSTs must maintain their status as passive investments, not an active business. As such, any direct involvement of investors in operations is not allowed. That means that calling for additional capital isn’t permitted after the offering is closed, as this constitutes direct involvement of interest holders. In addition, the entry of new capital can affect your ownership percentage and, by extension, your claim to the DST assets.
2. No Refinancing or Additional Borrowing
A DST sponsor, which serves as the trustee, also isn’t allowed to borrow new funds or renegotiate existing financing terms. The main reason this rule exists is to prevent sponsors from assuming more debts or refinancing into a new mortgage, which would then affect the value of the beneficiaries’ interests.
3. No Reinvestment of Proceeds
Any proceeds from the sale of the property cannot be reinvested by the trustee — they must be distributed to the beneficiaries. In other words, the DST sponsor has no right to use the sales proceeds to make a new investment. This act would constitute varying the investment and would violate the passive nature of the DST. It will be up to the investors, after they receive their share of the proceeds, to decide whether or not they will reinvest.
4. Limited Capital Expenditures
The trustee is restricted from making capital expenditures beyond normal repairs and maintenance, minor non-structural improvements, or those required by law. The DST is not allowed to make major capital improvements on properties, as this practice is seen to jeopardize the beneficial interests of investors.
5. Restricted Cash Investments
DSTs usually have reserves to cover contingencies. However, the trustee is only allowed to invest this cash for short-term debt obligations. Examples are government securities or certificates of deposit, which mature before the next distribution date. Major speculative cash investments, while they may promise increased income, are considered as varying from the investment. This is another violation of the passive nature of the DST.
6. Mandatory Cash Distributions
All cash income from underlying DST properties must be distributed to the beneficial interest holders. The DST is only allowed to keep cash for use in covering emergency maintenance or repairs. Otherwise, it must distribute all earnings to the investors on the agreed frequency. These restrictions prevent the misappropriation of funds, which could result in loss of tax-deferral eligibility.
7. Limited Lease Activities
The trustee cannot renegotiate existing leases or enter into new leases. The only time these practices are allowed is in limited circumstances, like tenant insolvency or bankruptcy. DSTs usually employ a master lease structure, which assigns a master tenant that takes charge of lease activities instead of the DST. This practice allows the DST to maintain its fixed investment trust status since another entity is handling lease activity.
Wrapping Up: DST Prohibitions Under Revenue Ruling 2004-86
DSTs must maintain certain standards and structures that allow continued eligibility for tax-deferral benefits. The sponsor or trustee is responsible for following rules like Revenue Ruling 2004-86 and avoiding the seven deadly sins. However, as an investor, knowing these prohibitions can help you become more discerning when it comes to choosing the DST investment. You’re more likely to choose one that is compliant, which lowers the chances of issues down the road.
Sources:
https://www.hellodata.ai/help-articles/what-is-a-master-lease-agreement-in-real-estate
https://www.biggerpockets.com/forums/104/topics/1234495-can-an-dst-make-a-capital-call
