Delaware Statutory Trusts (DSTs) are increasingly popular investment vehicles for executing 1031 exchanges involving real estate. If you’re familiar at all with DSTs, you have probably come across the term “Master Tenant”—a key concept in properly structuring a DST to meet the IRS requirements for 1031 eligibility.
It's unique to DSTs, and so much so that most investors aren’t familiar with the term. In this post I’ll answer two often asked questions:
- What exactly is a Master Tenant?
- What role does it play in a DST, and why is it required?
To answer these questions, we first need to cover some basic concepts of a Delaware Statutory Trust. A DST is a legal entity constructed under Delaware law whereby investors own shares of the trust (known as “Beneficial Interests”).
In a 1031 exchange transaction, the DST in turn owns one or more properties. In 2004, the IRS determined that Beneficial Interests in a DST would be treated as direct property ownership (i.e., like-kind replacement property), qualifying them for a 1031 exchange—subject to meeting seven restrictions. Arnie Harrison, the attorney who pioneered the concept referred to these as the "Seven Deadly Sins." The name is fitting because if these restrictions are not adhered to, the IRS may disqualify the exchanges of the investors in the DST.
The IRS’ stated objective was to make the DST a completely passive investment vehicle when used for like-kind exchanges. One of the Seven Deadly Sins is that the Trustee of the DST cannot enter into new leases or renegotiate current leases.
Wait, so the DST operates an income-producing real estate asset without the ability to negotiate leases? Sound crazy? Arni’s solution was to have the entire property leased by a Master Tenant under a single long-term lease known as the “Master Lease.” This way, the MT is able to operate the property through sub-leases with the property’s tenants.
Let’s assume a DST owns a 300-unit apartment complex. The MT leases the entire property from the DST and is responsible for operating the property (maintenance, keeping the apartments leased, collecting rent, paying operating expenses, etc.). In return, the MT agrees to pay the DST certain lease payments under the Master Lease, debt service of the property, as well as preferred return on investors’ capital. Each investor gets their proportionate share of the preferred return, based on the percentage of the DST they own.
The MT is typically an entity created and owned by the DST’s Sponsor, the person or firm who found the property, secured the mortgage, created the DST, and raised the equity from the investors. Like any real estate lease, the roles and responsibilities of the MT and the landlord (i.e., the DST) are defined in the Master Lease.
And now you know: the Master Tenant is an entity set up and controlled by the Sponsor for the sole purpose of leasing the DST’s property—and very importantly, avoiding the Seven Deadly Sins. For this reason, when evaluating a DST investment, the expertise and track record of the Sponsor is much more important than the Master Tenant.