Why are DSTs so popular?

Billions of real estate investment dollars flow through 1031 Exchanges into DST properties every year.  The popularity grows due to the streamlined process and timeliness these trusts provide.

DST Real Property

The Internal Revenue Service issued Revenue Ruling 2004-86 on August 16, 2004, which permitted the use of co-investorship or fractional interest as a structure of the Delaware Statutory Trust (DST).  These DST properties now qualify as replacement properties when completing a 1031 Exchange transaction.

Possible Advantages for the Investor

Why are DSTs so popular? Real Property 1031 ExchangeIndividual single member limited liability companies are not set-up as part of the DST Investment Property structure.  Individual investors own individual beneficial interests in the DST and the property held.  This “Beneficiary Ownership” eliminates the need to set up single-purpose, single-member LLCs for each investor.

The DST itself shields the co-investor from liability with respect to the underlying investment property owned and held inside the DST.  This saves the co-investor substantial annual expense with respect to the formation costs and annual fees associated with the single-purpose, single-member LLC.  It also provides a less complex structure.

There is no need for a lender to obtain copies of income tax returns, financial statements, or credit authorizations from each co-investor for purposes of loan qualification since the DST is the borrower and not each individual co-investor.  The result is that all leverage inside a DST is non-recourse to the beneficiary owner.

There is also no restriction on the number of investors in a DST.  As a result, larger properties can be purchased without causing investment minimums to rise to unacceptable levels.

Most importantly, the Delaware Statutory Trust or DST Investment Property structure qualifies for tax-deferred exchange treatment under Section 1031 of the Internal Revenue Code (“1031 Exchange”).

Why Lenders Like DSTs

DSTs prevent any potential creditors, lien holders/liens, or judgments of any of the co-investors from attaching to the investment property held in the Delaware Statutory Trust.  This provides the lender with greater security.

There is no one-year time limit for the contract with the property manager, so the lender will have comfort knowing that the DST Sponsor will be operating the property without interruption.

The beneficiary owners in a DST do not individually qualify for the loan nor do they have to go through any of the lender’s underwriting requirements because they are not the borrowers.  The DST is the borrower and the Trustee of the Delaware Statutory Trust executes all of the loan documents.

The Advantages of the Seven Deadly Sins

Internal Revenue Ruling 2004-86, which forms the income tax authority for structuring a Delaware Statutory Trust or DST transaction for use with a 1031 Exchange has prohibitions over the powers of the Trustee of the Delaware Statutory Trust of DST, which are known as the “seven deadly sins,” and include the following:

  1. Once the offering is closed, there can be no future equity contribution to the Delaware Statutory Trust (DST) by either current or new beneficiary owners.
  2. The Trustee of the Delaware Statutory Trust or DST cannot renegotiate the terms of the existing loans, nor borrow any new funds from any other lender or party.
  3. The Trustee cannot reinvest the proceeds from the sale of its real estate.
  4. The Trustee is limited to making capital expenditures with respect to the property to those for a) normal repair and maintenance, (b) minor non-structural capital improvements, and (c) those required by law.
  5. Any liquid cash held in the Delawre Statutory Trust or DST between distribution dates can only be invested in short-term debt obligations.
  6. All cash, other than necessary reserves, must be distributed to the beneficiary owners on a current basis, and
  7. The Trustee cannot enter into new leases or renegotiate the current leases.

Any DST trustee committing one of these “sins” would be working contrary to the beneficiary owners.  Therefore, these federal regulations are in place to protect the DST property exchanger and investor.

The Springing LLC

The DST agreement may contain a provision stating  “if the Trustee determines that the DST is in danger of losing the property due to an inability to act because of the regulations in the trust agreement (the seven deadly sins), it can convert the Delaware Statutory Trust (DST) into a limited liability company (hereinafter referred to as the Springing LLC) with pre-existing agreed-upon terms.

The laws of the state of Delaware permit the conversion to a limited liability company through a  filing with the office of the Secretary of State. The Springing LLC will contain the same bankruptcy remote provisions as the Delaware Statutory Trust for the lender’s benefit, but it will not contain the prohibitions against the raising of additional funds, the raising of new financing or the renegotiation or the terms of the existing debt or entering into new leases. In addition, it will provide that the Trustee will become the manager of the limited liability company.  This is in place to protect the property and its investors.