Commercial real estate is often subjected to a variety of micro and macroeconomic factors that can adversely affect property performance. Look no further than the retail and hospitality shutdowns that happen as a result of the coronavirus pandemic, and the ensuing work-from-home trend that continues to roil office markets throughout the country.
For properties held in a Delaware Statutory Trust (DST), there’s a “last-resort” contingency plan when properties significantly underperform or become insolvent. A Springing LLC is a Limited Liability Company that is created in the event that the DST does not meet investor expectations. The Springing LLC is typically used to protect investors from financial loss if the DST becomes insolvent.
The structural composition of Delaware Statutory Trusts – primarily, the passive nature of the trust and its inability to perform certain functions that are allowed under other investment vehicles, may lead to some investor concern. In the event that something goes awry and a DST significantly underperforms, there are actions that can be taken to “right the ship.” In essence, a Springing LLC provides a safety net for DST investors.
In order to meet 1031 exchange eligibility, DSTs are structured as passive investment vehicles for holding commercial real estate, with minimal powers afforded to the Trustee (you can learn more about that here). To counter this issue, DSTs typically contain a conversion feature in their operating agreements. If the Trustee believes that the DST is in danger of losing the property due to insolvency or structural restrictions, the DST may be converted into a Limited Liability Company (LLC) with pre-arranged terms.
The Springing LLC contains the same protections as the DST, but it does not prohibit raising additional equity, renegotiating existing debt, obtaining new financing, or entering into new leases. In addition, it provides that the Trustee will become the manager of the LLC. The operating agreement of the Springing LLC is created prior to the close of the DST in order to eliminate any ambiguity as to the rights and procedures after the change is made.
Once a DST is converted into a Springing LLC, it will be treated as a partnership for federal income tax purposes. Investors will not be able to do a 1031 exchange if the LLC sells the asset. However, there are no prohibitions against the LLC converting back into a DST after making any necessary adjustments or modifications. In the worst-case scenario, investors may lose their tax-deferral benefits upon sale, but at least there is the ability to protect the initial capital investment through restructuring, raising new capital, or executing new leases.