From: New Jersey Law Journal
Author: Joseph J. Whitney, David Shechtman and Angela R. Raleigh
Date: October 23, 2017

Case Digest Summary

In recent years, DSTs have grown in popularity as replacement properties for real estate owners seeking to reinvest sale proceeds into net-leased properties producing a steady stream of income.

Section 1031 of the Internal Revenue Code is an important tool that allows real estate investors and property owners to exchange one business or investment property for another without immediately incurring taxes. This transaction, often referred to as a “1031 exchange” or “like-kind” exchange, allows an investor to reinvest the full amount of net sale proceeds into new investments while deferring capital gain taxes until the investor eventually cashes out.

In recent years, Delaware statutory trusts (DSTs) have grown in popularity as replacement properties for real estate owners seeking to reinvest sale proceeds into net-leased properties producing a steady stream of income. The DST’s structure also permits investors to engage in a subsequent 1031 exchange if they decide to sell their beneficial interest in the trust or when the trust terminates. However, in order to receive such tax-deferred treatment, DST investors
should be aware of several important restrictions and limitations.

A DST is a statutory form of business trust governed by Del. Code Ann. Title 12, §3801–62. Generally, business trusts enjoy many benefits similar to limited liability companies, including pass-through taxation, insolvency protection, limited liability for both the trustee and investors, and flexibility in arranging the trust’s governance structure. This flexibility allows investors to structure DSTs to impose specific limits on the trustee and trust property necessary to satisfy the requirements to treat a beneficial interest in the DST as a direct interest in real estate for tax purposes. In order to facilitate 1031 exchanges, DSTs hold investment property in fee simple and allow investors to purchase a pro rata beneficial interest in the trust. A DST typically exists for a limited period of time, as provided by the trust’s governing instrument, until the trust property is sold on behalf of investors. Upon termination, the trustee distributes the net sale proceeds to the beneficial owners in accordance with their pro rata interests, and, if the DST has been properly managed, each owner may reinvest its pro rata share in another 1031 transaction. An investor can also sell his or her interest prior to the trust’s termination, and use the proceeds to commence another 1031 exchange.

Prior to utilizing DSTs, investors looking to pool money for larger 1031 replacement property investments were limited to entering into tenancy-in-common (TIC) arrangements. TICs were not and are not without their own limitations. Revenue Procedure 2002-22 (2002) (the “TIC Revenue Ruling”) imposes certain requirements which must be met in order for the TIC arrangements to be respected as a direct ownership of real property (and thus, eligible as 1031 replacement property) and not re-characterized as a tax partnership (ineligible for 1031 treatment). The TIC Revenue Ruling limits TICs to no more than 35 co-investors. TIC investors typically create single-purpose, single-member limited liability companies to hold their undivided interests and shield themselves from liability. Those individual limited liability companies must then jointly arrange for financing, creating a potential closing nightmare for lenders in having to deal with up to 35 separate borrowers. The TIC Revenue Ruling also requires unanimous consent of all TIC coinvestors on all major decisions (including leasing and refinancings), which can make for a burdensome governing structure. Because the DST structure solves many of the limitations imposed by the TIC Revenue Ruling, use of DSTs has increased. For instance, the DST itself shields investors from liability, acts as the sole borrower for any loans, and centralizes management with the trustee.

Like an investment in a TIC structure (but unlike an investor who acquires ownership of a membership interest in a limited liability company), an investor in a DST may be treated as owning an undivided interest in the property itself. Accordingly, a properly structured DST can avoid Section 1031′s prohibition on exchanges of partnership interests because beneficial owners are considered to be selling and exchanging a portion of real property, not an interest in an entity.

In Revenue Ruling 2004-86 (2004), the Internal Revenue Service specifically approved the use of DSTs in 1031 exchanges (a “1031 DST”), but established prohibitions on the DST trustee’s powers and activities (now known as the “seven deadly sins”) to ensure that the DST acts more like a typical passive “investment trust” than an operating business entity.

A 1031 DST must have only a single class of beneficial interests and the trustee must:

  1. Not renegotiate or modify existing mortgage loans or obtain any new mortgages;
  2. Ensure that all cash held by a DST may be invested only in short term debt obligations;
  3. Not obtain future capital contributions to the DST once the initial offering is closed;
  4. Not reinvest the proceeds from the sale of DST property in new investments;
  5. Not enter into new leases or modify existing leases except where a tenant is bankrupt or insolvent;
  6. Not make capital expenditures on the property other than for
    (a) normal repair and maintenance of the property;
    (b) minor non-structural capital improvements of the property; and
    (c) legally required repairs or improvements; and
  7. Distribute all net cash to beneficial owners at least quarterly.

The purpose of the seven deadly sins is to limit the trustee’s ability to modify the investment. The Internal Revenue Service takes the position that passive investment in a DST restricted by the seven deadly sins is akin to ownership of property as opposed to ownership of an interest in a partnership. If a DST trustee has the power to violate any of the above rules or can change the investments of the DST, the trust will be classified as a business entity, thereby precluding the DST’s beneficiaries from acquiring their interests as 1031 replacement properties. As a result, each DST structure must carefully navigate around the “seven deadly sins.”

Because a DST trustee cannot renegotiate the terms of a mortgage or obtain a new mortgage, and because beneficial owners cannot make additional capital contributions to the DST, any loan on the property must have a maturity date that is later than the proposed dissolution of the DST. This will permit the trustee to sell the property before themortgage expires. Property that is under construction or subject to a construction loan that must later be renegotiated is an inappropriate choice for 1031 DST property. A 1031 DST should also ensure that the initial investment in the DST provides for sufficient cash reserves to operate because the trustee cannot arrange for new financing or raise additional capital.

Because the Revenue Ruling restricts DSTs from renegotiating leases or entering into new leases, most DSTs hold properties with triple-net leases or enter into triple-net master leases with a DST sponsor-affiliated master tenant (an arrangement which is subject to other restrictions outside of the scope of this article). The master tenant may then enter into subleases with subtenants, thereby allowing leasing to various types of tenants, such as long-term, creditworthy tenants or tenants with short-term leasing cycles, like multi-family residential housing. When a 1031 DST is leasing property either directly to a triple-net tenant or to a triple-net tenant through a master lease, the term of the lease should extend past the proposed term of the DST so that there is ample time remaining on the lease when the property is being marketed for sale, thus attracting more buyers. Because a 1031 DST may make only specific types of improvements to the property, such as minor non-structural capital improvements and normal maintenance, DSTs typically choose to own newer properties that will not require significant repairs over the life of the DST or choose to own properties that are triple-net leased to a creditworthy tenant that is obligated to perform all maintenance and repairs.

As for distributions, the trustee of a 1031 DST must distribute net cash proceeds from the ownership of the property on a pro rata basis, meaning that there cannot be separate classes of beneficiaries or preferred interests. The trustee may not reinvest any cash, save for in short-term debt obligations. This prohibits the DST from participating in any investment other than ownership of a single property. The trustee also may not reinvest the proceeds from the sale of the DST property. Once the DST property is sold, the trustee must distribute the proceeds from the sale of the property to the beneficial owners pursuant to their pro rata shares. Provided the DST was structurally compliant and did not commit any of the seven deadly sins, the beneficial owner would then have the right to use its share of the sale proceeds to purchase replacement property under Section 1031 and participate in another 1031 exchange.

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