The state of Delaware is a nationally recognized leader in statutory trusts due to legislation that overrides the principles of common law trusts. The popularity of Delaware Statutory Trusts, or DSTs, has grown in popularity since the state in 1988 adopted the Delaware Statutory Trust Act.
Although many states have since enacted similar legislation, Delaware’s groundbreaking trust law remains at the forefront of statutory trust legislation for a number of reasons. In this article we’ll examine how DSTs function in structured financial transactions and why they remain the preferred trust entity for real estate investors.
How Delaware Statutory Trusts are Formed and Maintained
One reason why DSTs have grown in popularity since the DST Act of 1988 is that they are easy to form and maintain. A Delaware Statutory Trust is created by filing a certificate of trust with Delaware’s Office of the Secretary of State, which comes with a one-time filing fee -- there are no annual fees to maintain the trust.
The only publicly disclosed information stated on the certificate of trust is the name of the trust itself and the name of a Delaware-based trustee. This provides anonymity for investors, who are the beneficiaries of the trust. While the trustee must be based in Delaware, the trust can be run by an out-of-state Sponsor or manager.
Legal Structure of DSTs
Another reason why DSTs have become popular investment vehicles is because of the different protections they provide to investors.
DSTs are bankruptcy remote, which isolates investors from financial risk and minimizes the impacts of bankruptcy. DSTs are created as legal entities that are separate from the trust’s beneficiaries and managers. Investors, therefore, are shielded from incurring debt or other financial obligations if the asset within the trust takes a turn for the worse. Oftentimes, DSTs are formed with a singular asset. Regardless of the asset’s performance, investors aren’t exposed to remediation from creditors for any liabilities or obligations incurred by the asset.
These limitations provide a degree of protection and risk management for beneficiaries. However, beneficiaries also are subject to certain rules and regulations that are the backbone of Delaware Statutory Trust laws.
A pool of beneficiaries purchase fractional interests in the trust, but the trust wholly owns any assets within the trust. Beneficiaries have no say in the management or operation of these assets -- the trust Sponsor or a third-party management firm makes all business decisions. The only right of beneficiaries is to receive distributions from the trust, when applicable.
The trust Sponsor is subject to a host of IRS restrictions as well. These include:
- Cash reserves generated from the asset’s operation must be distributed to beneficiaries -- it cannot be reinvested.
- Once the offering closes, the Sponsor cannot take on any additional investors.
- Sponsors cannot be involved in lease negotiations with tenants, and they can’t renegotiate any existing loans on the property for more favorable terms.
- Sponsors can only fund minor repairs and routine maintenance.
Because these restrictions are built into the trust agreement, DSTs are formed with master lease transactions or with creditworthy triple-net tenants who assume all operating responsibilities for their properties.
There are other important laws around Delaware Statutory Trusts as well. They typically have holding periods between five and 10 years. There is no limit to the number of investors who can participate in the DST, although the investors pool is capped when investment funds displace the Sponsor’s original investment amount. Lastly, but perhaps most importantly, the IRS views fractional interests in DSTs as real property interests, which qualifies them as replacement properties for 1031 exchanges.
Delaware Statutory Trusts are rigorous legal structures that don't allow for a lot of flexibility -- and that can be both good and bad for investors. Discuss the potential merits of investing in DSTs, as well as the unique laws and ownership structure of DSTs, with your certified financial planner.