Delaware Statutory Trust
The IRC 1031 tax-deferred exchange is one of the most powerful wealth building tools available to the US taxpayer. Savvy real estate investors know that deferring capital gains has an exponential power for wealth creation. However, when investing smaller quantities of capital, such as $50,000 or $100,0000, there are challenges to investing in real estate. Securing a loan, management limitations, and the typically high price for well located, quality real estate are all intimidating and inherent barriers to real estate investment. Fortunately, there is a solution; the Delaware Statutory Trust, or DST.
What is a Delaware Statutory Trust
A Delaware Statutory Trust is a separate legal entity created as a trust under the laws of Delaware in which each owner has a “beneficial interest” in the DST for Federal income tax purposes and is treated as owning an undivided fractional interest in the property. In 2004, the IRS released Revenue Ruling 2004-86 which allows the use of a DST to acquire real estate where the beneficial interests in the trust will be treated as direct interests in replacement property for purposes of IRC §1031.
This is an important distinction because the 1031 tax-deferred exchange code does not allow partnerships, such as an LLC or LLP, to hold interest in real property. In the DST, the real estate is owned by the trust, and the investors own their pro-rata shares of the trust. Thus, the funds used to acquire the shares are eligible for 1031 tax-deferred treatment.
The Benefits of a Delaware Statutory Trust
No Unanimous Approval From Owners
In any collective ownership structure, unanimous, or even majority approval of the investors is always a deterring challenge. This was witnessed in 2008 when the rigidity of the Tenant in Common (TIC) structure came to fruition. Due to unanimous approval provisions, one investor could refuse any action the majority of the group desired. In the DST structure, one trustee is authorized to make all decisions regarding the management and well being of the property and investment, thus mitigating the “rogue” investor risk.
Since the Trust, and not the investor are the borrower, financing is easier, and less costly. Investors in the DST do not need to be qualified, nor does the trust have any effect on their credit rating.
Limited Personal Liability
The DST has a bankruptcy remote provision, thus investors do not need to hold the investment in an LLC. If the event the trust fails, creditors would be limited to the assets of the trust, and unable to reach the personal assets of the investors.
Because there is no need to set up an LLC, there would be no LLC management, and no LLC taxes. This also negates any closing costs.
Lower Minimum Investment
A DST allows for up to 499 investors, therefore investment amounts can be smaller. Typically $10,000 for a new cash investment, $100,000 for 1031 exchanges. The DST Master Lease
The Restrictions of a Delaware Statutory Trust
In the DST structure, the trustee is restricted from many actions that would otherwise be normal in typical ownership structures such an LLC.
The trustee may not renegotiate leases, make capital calls, or even re-finance the property. Therefore, a master lease, or long-term triple net lease is necessary to circumvent these restrictions, and mitigate the risk associated with these restrictions.
THE SEVEN NO-NO’s of a Delaware Statutory Trust
IRS Revenue Ruling 2004-86, which forms the basis for a DST transaction in a Section 1031 exchange program, has prohibitions on the powers of the trustee, in order for a beneficiary to be treated as acquiring a direct interest in real estate for tax purposes. These restrictions are built into the trust agreement.
- Once the offering is closed, there can be no future contributions to the DST by either current or new beneficiaries.
- The trustee cannot renegotiate the terms of the existing loans and cannot borrow any new funds from any party unless a loan default exists as a result of a tenant bankruptcy or insolvency.
- The trustee cannot reinvest the proceeds from the sale of its real estate.
- The trustee is limited to making capital expenditures with respect to the property for normal repair and maintenance, minor non-structural capital improvements, and those required by law.
- Any reserves or cash held between distribution dates can only be invested in short-term debt obligations.
- All cash other than necessary reserves must be distributed on a current basis.
- The trustee cannot enter into new leases or renegotiate the current leases, unless there is a need due to a tenant bankruptcy or insolvency.
Because of these IRS restrictions, there are really only two forms of tenancy that are compatible with a DST structure.
- Long term NNN leases to a high credit tenant.
- Master Lease
Further, a properly structured DST should own real estate investments with the following characteristics:
- Acquiring only new or recently rehabilitated Class A properties;
- Raising substantial funds for capital reserves in the offering;
- Having financing terms which go out 7 to 10 years, but less than the term of the master lease; and
- Planning for the sale of the mortgaged property prior to the maturity date of the loan.
The Springing LLC
In the event any of the above seven restrictions need to be violated, there is a way out. Delaware law permits conversion of the trust to an LLC. This is referred to as a “springing LLC”. This will allow for any or all of the prohibited actions to be preformed, but will disqualify any of the tax-deferral benefits. The springing LLC give the lender additional comfort that the trustee can perform necessary actions in the best interest of the property (lenders collateral).
The Master Lease
In a master lease, a master tenant (usually the sponsor or affiliate of) will lease the property from the trust, and pay rent (master lease payment) to the trust. The master tenant, then sublets the property to the tenants, and in effect can legally circumvent the operational restrictions mentioned above.
In the master lease structure, the master tenant (effectively the sponsor) pays a pre-determined “rent” to the trust, covering the debt plus a specified return. The master tenant is entitled to keep all the property level net income that is above the debt service and master lease payment This structure provides aligned interests, because the master tenant is incentivized to maximize rents and avoid income shortfalls.
It is also important to note because there is no real ability to negotiate changes in the master lease terms and rent payments with the DST trustee, sponsor typically reserve more capital upfront for any unanticipated repairs and expenses. These reserves are in addition to the typical lender required reserves.
This above is not an offer to sell, or a solicitation of an offer to buy, securities. Offers can only be made through the Offering Memorandum. DST Units may be sold only to “accredited investors,” as defined in Regulation D under the U.S. Securities Act of 1933, as amended (the “Securities Act”), which, for natural persons, refers to investors who meet certain minimum annual income or net worth thresholds. DST Units are being offered in reliance on an exemption from the registration requirements of the Securities Act and the laws of any U.S. State or non-U.S. jurisdiction, and are not required to comply with specific disclosure requirements that apply to registration under the Securities Act. Neither the U.S Securities and Exchange Commission nor any other regulatory authority has passed upon the merits of an investment in the DST Units, has approved or disapproved of the DST Units or passed upon the accuracy or adequacy of the offering materials describing the securities. This brochure does not purport to be complete and should be viewed in conjunction with the Offering Memorandum. An investment of this sort is speculative and involves a high degree of risk. Projections of future performance contained herein are based on specific assumptions discussed more fully in the Offering Memorandum and do not constitute a guaranty of future performance.