Many investors have recognized the benefits of Delaware Statutory Trusts (DSTs), making these investment vehicles very popular today. From tax-deferral benefits to passive income, DSTs have many advantages that make them suitable for those near retirement and those who want hands-off involvement in their assets.
One question that investors often ask is: How does refinancing work in DST properties? Is refinancing DST properties even allowed? Below, Realized 1031 has shared comprehensive answers to these questions to help you understand what’s at stake. Let’s take a closer look.
The Seven Deadly Sins of DSTs
One of the reasons why DSTs are popular is that they are eligible for 1031 exchanges. Under Revenue Ruling 2004-86, DST interests are eligible for the like-kind swap, allowing investors to defer capital gains taxes. However, this qualification comes with a few conditions. The most well-known rules are the so-called seven deadly sins. Trustees — the sponsor or their affiliate — are prohibited from doing any of the following.
- Raising new capital from existing investors
- Reinvesting proceeds from the sale of property
- Renegotiating existing loans or obtaining new financing
- Entering into new leases or renegotiating current ones
- Making significant capital improvements or expenditures
- The DST doesn’t distribute income to investors on a current basis
- Engaging in business activities other than collecting rent
Point #3 becomes significant in our discussion. Renegotiating or refinancing debt is not allowed once the DST is established and investors have entered. Doing so would violate the IRS rules and disqualify the DST from 1031 exchange benefits.
When Is DST 1031 Refinance Allowed?
Refinancing is allowed, even encouraged, before the DST is established and the offering is closed. Structuring financing is a common practice to help secure acquisition loans or refinance prior debt when the property is initially purchased and packaged for investors. In some cases, financing is necessary since the pooled funds from investors aren’t enough yet to acquire the DST property.
One condition for pre-acquisition financing is that it must be non-recourse debt. This won’t be much of a concern for investors since it’s the sponsor handling the financing. Non-recourse debt is required to help protect beneficiaries from personal liability if the DST has unmet debt obligations. Finally, the debt must be fully disclosed in the Private Placement Memorandum (PPM). Once investors are in, the financing terms are fixed and cannot be changed.
Springing LLC: A Last Resort Option
What if there are extraordinary circumstances that make refinancing an absolute necessity to keep the DST property from foreclosure? Thankfully, there is one way to make refinancing possible: by converting the DST into a limited liability company or LLC. This mechanism is called a springing LLC, and it’s typically included as a contingency feature used during adverse circumstances. These include imminent loan default, tenant bankruptcy, or economic distress.
When the DST is converted, it’s no longer bound by the seven deadly sins and is thus free to refinance debt. There is a critical trade-off, however. Conversion to an LLC disqualifies the investment from future 1031 exchanges. Once the DST liquidates, you will be liable to pay capital gains taxes. As such, it’s important to recognize springing LLCs as a last-resort option and not a tool for improving financing terms.
Wrapping Up: DST Refinance Basics
Refinancing Delaware Statutory Trust properties is only possible before the DST is established. Sponsors cannot do so after the formation because it violates a core provision that allows DSTs to qualify for 1031 exchange benefits. However, springing LLCs are still a possible last resort, but you’d lose the ability to continue any exchanges after the conversion.
Sources:
https://www.nolo.com/legal-encyclopedia/what-is-private-placement-memorandum.html
