Investors who are looking for properties to complete their 1031 exchanges often ask us if there are “arm chair investments” that allow investors to own fractional shares of properties. The good news is that the IRS has blessed the Delaware Statutory Trust (DST) for use as 1031 replacement property. Investors purchase interests in the Trust, which holds title to property. Investment in the real estate is shared amongst many investors. DST properties are institutional grade commercial properties, including properties such as apartment
complexes, office buildings, retail buildings, and shopping centers.
Sue Speidel, Vice President of Inland Private Capital Corporation, has authored the below article which provides a great overview of DSTs.
Understanding the Delaware Statutory Trust (DST)
Investing in a multiple-owner DST which holds real estate may be a smart strategy to consider for cash investors, looking for 1031 replacement property. In addition to the tax benefits of owning real estate, and the benefit of having no hands-on property management responsibilities, investors will be poised to do a 1031 exchange upon the profitable sale of their real estate.
A Delaware statutory trust, or “DST,” is a legal entity created as a trust under Delaware law. One of the many business uses for the DST is to hold real estate. In the context of real estate, DSTs are formed pursuant to private governing agreements under which a property or several properties are held, managed, administered, and/or operated for profit by a trustee for the benefit of the holders of the DST’s beneficial interests.
In Revenue Ruling 2004-86, the Internal Revenue Service affirmed, among other things, that a beneficial interest in a properly structured DST that holds real estate would be considered to be of “like-kind” to a direct ownership interest in real estate in an IRS Section 1031 exchange. Often used in multiple-owner, securitized programs, benefits of the DST structure exist for both the exchanger and, if a property is financed, the lender. Among
these benefits are the following:
• The lender makes only one loan to one borrower (the DST).
• The trust agreement is written to prevent creditors of the exchanger from reaching the DST’s property, therefore making it bankruptcy remote.
• The DST shields the exchanger from any liabilities with respect to the property.
• Exchangers have no operational control over the management of the DST or its property.
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• Because exchangers have no operational control over the DST, the lender has no need to perform due diligence on individual exchangers.
• Because exchangers have no operational control over the DST, exchangers should also not be required to sign any indemnifications or guarantees.
Although the DST has many attractive features, care must be taken to follow the prohibitions on the power of the trustee, as described in the Revenue Ruling.
• No capital contributions may be made by new or existing beneficiaries after the offering is fully subscribed.
• The DST cannot renegotiate its existing mortgage debt or enter into new or replacement mortgage debt unless a property tenant is bankrupt or insolvent.
• The DST cannot renegotiate its existing lease(s) or enter into new leases or lease extensions unless a property tenant is bankrupt or insolvent.
• The trustee cannot reinvest proceeds of the sale of its real estate.
• Capital expenditures may only be made for normal repair and maintenance or improvements required by law.
• Any cash held between distributions may only be invested in short term debt obligations.
• All cash, other than reserves, must be distributed on a current basis.
Interest in DSTs is likely to get a boost from provisions in the Jumpstart Our Business Startups Act (the “JOBS Act”), which are expected to loosen regulations which apply to how a DST can solicit investors in the context of a private placement offering.
Given the intricacies of purchasing suitable real estate assets and structuring these offerings, from both a securities and tax perspective, exchangers and their advisors should perform due diligence when selecting a program sponsor. Emphasis should be placed on real estate, property management and asset management expertise, prior performance track record, experience with sophisticated financing structures, transparent investor communications, financial strength of the sponsor and excellent legal representation.
The real estate investments discussed in this article are suitable only for accredited, high net worth investors as defined in Regulation D of the Securities Act of 1933, as amended. Each investor’s tax circumstances are unique, and this article does not constitute tax advice for any particular investor. Prospective Investors should consult with their own tax advisors.