Investors find Delaware Statutory Trusts (DSTs) appealing because the structure allows for hands-off involvement, enhanced diversification, and tax deferral through 1031 exchanges. The same structure that provides these advantages, however, creates certain limitations, such as the fact that DSTs cannot make capital calls to address repairs and other contingencies.
Why does this happen? Do DSTs have protocols to manage these expenses? Realized 1031 shares the answers in this in-depth guide. Keep reading to learn more.
Revenue Ruling 2004-86 vs DST Capital Calls
In the context of investing, a capital call is a formal request by an investment firm that asks the investors to contribute a portion of their capital to finance certain activities within the investment. These activities include major capital repairs or upgrades that improve the value of the asset.
Most types of real estate investment structures allow for capital calls, but not DSTs. The restriction comes from Revenue Ruling 2004-86, which allows DST interests to qualify as like-kind property provided that the DST is structured in a certain way. In particular, the DST is prohibited from the following.
- Renegotiate leases or finance terms after the offering is closed
- Reinvest sale proceeds into new properties
- Raise additional capital from investors after the offering is closed
The last rule is particularly important in this discussion. DSTs function as passive and static investments, and investors providing additional funds through a capital call would ultimately mean that they’re involved in business operations. This practice would immediately violate the DST’s eligibility for the 1031 exchange tax deferral.
The Role of Reserves and Contingency Planning
If the situation calls for additional funding, and DSTs aren’t allowed to ask for more capital, then what can they do? There are two avenues to take.
DST Reserves
Most DSTs already have plans to set reserves before the offering is closed. The DST reserve is a dedicated fund that remains untouched unless a major event occurs, including the following.
- Routine maintenance and repairs
- Vacancies
- Turnover costs
- Unforeseen capital expenditures
Contingency Planning
DST sponsors also have comprehensive protocols that help avoid unexpected events from happening. For example, they may only work with creditworthy tenants to minimize vacancies. The firm may also purchase assets in great condition or work with trusted property managers to avoid the likelihood of expensive emergency repairs.
What If Major DST Repairs or Emergencies Arise?
The first line of defense for DSTs when major expenses arise is drawing from the reserves. When necessary, making an insurance claim can help cover or offset the repair costs without affecting distributions. If these two options are not enough, that would be the only time the DST will take from rental income and reduce distributions to investors.
The last resort is to change the DST into an LLC through a springing LLC provision. Through this conversion, the LLC can now access other financing options, including capital calls. However, this event disqualifies the structure from 1031 eligibility, resulting in a taxable event.
Wrapping Up: Handling Major Capital Repairs in DSTs
Capital calls in DSTs aren’t allowed to maintain the passive nature of the investment. As such, reserve funds and other protocols are employed to address major repairs and other unexpected events. When choosing a DST offering, you should also check if such steps are in place to protect your investment.
Sources:
https://dictionary.cambridge.org/us/dictionary/english/capital-reserve
https://carta.com/learn/private-funds/management/capital-calls/
