Despite their benefits, “fractional” 1031 investments do have their structural nuances. One particular issue where there is often some confusion is regarding the inability of a Delaware Statutory Trust (DST) to sign leases. Rational investors are probably asking themselves how their investment property can function without the ability to handle a basic task of property management. Fortunately, there is a simple solution – the Master Lease.
Under the DST structure, the Trustee of the DST is prohibited from entering into new leases or renegotiating existing leases. On the surface, this certainly appears problematic for prudent property operations. However, when the DST is formed, the Trust may enter into a Master Lease agreement. Under the Master Lease agreement, the entire property is leased to a Master Tenant, which is usually a subsidiary of the Sponsor. This lease is typically long term with multiple extension options. The Master Lease typically requires the Master Tenant to assume all property operating responsibilities and, most importantly, allows the Master Tenant to sublease space to end-user tenants of the property. The Master Tenant may also enter into property management contracts or sub-management arrangements.
This set-up allows the Trustee to refrain from making any property operating decisions because doing so could jeopardize the tax-deferred status of the Trust’s beneficiaries. For this reason, the Master Lease is deemed to be a true lease and not a financing or partnership. As a true lease, the Master Tenant, as the property’s sole tenant, must make lease payments to the DST. The lease payments are typically structured to equal the required debt service payments plus a stated return to the beneficiaries.
Although this arrangement may sound a bit cumbersome at first blush, it is a tried and true structure and very familiar to experienced DST sponsors. Most importantly, it allows for leasing activity and to otherwise properly manage the property while ensuring compliance with tax regulations.
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