DST 1031 Exchange
Investors get a passive investment option in Delaware Statutory Trust (DST) investments which still qualifies as “like-kind” property in a 1031 exchange. Based upon IRS Revenue Ruling 2004-86 (DSTs) these securitized investment structures give 1031 exchangers an option to go beyond single owner traditional real estate options as replacement properties
What is a Delaware Statutory Trust (DST)?
A Delaware Statutory Trust (DST) is a separate legal entity which is created as a trust under Delaware statutory law, which permits a flexible approach to the operation and design of the entity. Investors in a DST have the right to receive distributions from the operation of the trust, either from sale or rental income of the property. They also own a pro rata interest in the trust. Investors do not have deeded title to the property. Trust itself has deed to the property and who, through the signatory trustee, makes the all the decisions regarding the disposition of the property including its eventual sale. The beneficiaries (Investors) of the trust have no control over the day to day management of the property or the timing and details of its sale. While initially this seems to be not a good deal to the investor, DST structure opens up the possibility for many advantages. Check DST Benefits Section to know more
IRS Revenue Ruling 2004-86 created a path for DST’s to be used for the purposes of a 1031 tax-deferred exchange. This revenue ruling states that a beneficial interest in a DST which owned real estate would be considered a “direct interest in real estate” and thus qualify for 1031 exchange, assuming of course that all the other requirements are satisfied. Since the year 2000, DSTs have increasingly been used as a form of asset protection, tax deferral, and balance sheet advantages in securitization, real estate, and mezzanine financing. IRS Revenue Ruling 2004-86 paved the way for Delaware Statutory Trusts to become the most popular ownership structure used by smaller investors to own investment-grade properties together with different other investors.
Due to the nature of DST financing and legal limitations, the use of a Delaware Statutory Trust will generally be confined to long-term “A” credit triple-net leased properties (“box-in-one”) or properties leased to an affiliate of the sponsor (a master tenant) who will manage the property on a triple-net basis (a master lease). Because of the additional problems seen with TIC ownership structures during the Great Recession, the trend to use DST as 1031 Exchange only got stronger. Today about 80% of the securitized real estate offerings for 1031 exchange are DSTs.
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the Financing and Lender Issues in DST
The Delaware Statutory Trust structure has to a very greater extent simplified the process for financing securitized real estate and gives the investors options to very competitive interest rates which are generally only available to institutions. This is made possible because the trust owns 100% of the fee interest in the property and is the sole borrower. It is completely different from a TIC program where there can be up to 35 individual borrowers, and every individual needs to be approved by the lender, while in DST the lender only needs to make one loan to one borrower.
Institutional Lenders are more likely to be attracted towards a well-structured DST which owns investment-grade real estate because of the proven track record in property management of the sponsor, and for the reason that DSTs are bankruptcy remote, that is, they have a special purpose entity provisions which prevent the DST’s property to be reached by the bankruptcy creditors of the beneficiaries. This give an assurance to the lender that they can foreclose on their first mortgage of the property whenever the need arises.
Furthermore, the lender does not need to qualify or underwrite any of the individual investors. Other than Patriot Act considerations, due diligence investigations are normally not necessary of the investors. And, the need for the lender to monitor transfers of beneficial interests is eliminated as the better sponsors only sell to accredited investors.
Finally, there is generally no need for individual DST investors to sign any non-recourse loan carve-outs because the they have no vote in the management of the property. In the primary loan, the lender deals directly on the matter of carve-outs with the trust. In the Standard carve-outs for environmental damages and investor fraud are executed by the DST trustee, according the DST investor an absolute non-recourse loan. The DST investor is not personally responsible for the repayment (non-recourse) of the loan, and the loan does not affect the individual investor’s personal credit score.
The Tax law requires that the trustee of the Delaware Statutory Trust, be prohibited from taking certain actions with respect to financing, leasing and capital-raising for the real estate. Also, the Investors of the trust have no control over the management of the mortgaged property. So, either a long-term triple-net lease or a master lease to a credit tenant is required.
The master tenant (often an affiliate of and controlled by the sponsor) will sublet the property to residential or commercial tenants in the case of a master lease. The master tenant also handles repairs and maintenance, and contracts with the operation agent (generally an affiliate of the sponsor). In common language, the master tenant is authorized to do everything that an owner of the property would be authorized to do. This kind of master tenant/master lease arrangement overcomes the requirements of the law, is very lucrative to institutional lenders, and also, eliminates the concern as to how to ensure the unanimous consent of the tenants-in-common to certain necessary management actions raised in TIC transactions.
Adding one more layer of bankruptcy protection for the lender is that the master tenant would also be structured as a Special Purpose Entity. Because most master tenants will be minimally capitalized, the sponsors will own and control the master tenant and have the liquidity and requisite net worth to satisfy lender requirements.
Additionally, the good sponsors self-reserve from net operating income for uninsured losses and unanticipated repairs, because there is no real ability to negotiate changes with the DST trustee in the master lease terms and rent payments.
Risks of Delaware Statutory Trusts (DSTs)
- Risk of relying upon the continued competency and success of your program sponsors
- Risk of the sponsor insolvency
- Risks associated with giving complete discretion regarding the leasing, management or sale of the property to a third party
- Risk of being unable to re-finance the program at the end of the term of said loan, if the property held by the DST is leveraged
- Risk of possible conflicts of interest with program trustees, sponsors or property managers