7 Deadly Sins: What a funny title for a law about DSTs!
Betty Friant, Senior Vice President overseeing the Washington DC office of Kay Properties recently interviewed CEO and Founder, Dwight Kay about a very important topic for anyone investing in DST Properties
Betty Friant: Dwight, thanks for taking the time to dig into a very important part of what a DST is and how it works. We’ve all heard of Snow White and the Seven Dwarf but how many people have heard about DSTs and the Seven Deadly Sins? Can you give us a brief overview of what we are talking about here?
Dwight Kay: Certainly. There are a number of guidelines for the sponsor to account for when putting together a DST. In order to meet the requirements established by the IRS to qualify as “like kind” for the purposes of a 1031 exchange, the DST must follow 7 guidelines established by the IRS.
Friant: That makes sense. Let’s dig into the rules. The 1st guideline says that once the offering is sold out, there can’t be any future contributions to the DST.
Kay: Correct. Since there can be no capital calls of investors during the hold period, any future needs for capital expenditures need to be planned out well in advance and raised in the initial offering. Just like one of us might set aside funds to replace a roof at a later date on a rental property, the needs of the properties in the DST must be funded in advance.
Friant: Got it. The 2nd guideline says that the DST can’t renegotiate the terms of the loan or borrow new funds. How may this affect the DST?
Kay: Since the DST can’t extend the loan, often DSTs are sold before the mortgage is due which allows the investors to roll into another 1031 Exchange. This rule against refinancing makes it prudent for our investors to focus on DST offerings that either a) have a long term loan of at least 10 years or b) purchase DSTs that are debt free meaning that are owned free and clear with no loans.
Friant: The 3rd rule is basically an add on to the sale scenario. It says that the Trustee can’t reinvest the proceeds from a sale.
Kay: That’s right. The Trustee can’t keep the money and reinvest it for the investors. The investors have the opportunity to take their prorated portion and do another 1031 or go ahead and pay their taxes which can include state and federal capital gains, depreciation recapture, and the Medicare Surtax, too. So when a DST property sells the investors have a handful of options… If they want to exchange into more DSTs, they can. If they want to exchange into more investment real estate they would manage on their own, they can. Or if they want they can pay their taxes and cash out. In a situation like a REIT or Fund the sponsor company often will sell a property and reinvest the proceeds into another property thereby limiting the investors options. Even if the REIT or Fund sponsor makes a distribution to investors from a property sale those investors will be subject to taxation as they will not be able to proceed with a tax deferred like kind 1031 exchange. With the DST investors have options.
Friant: Number 4 in the guidelines has to do with how to hold any cash that the DST has at any given time.
Kay: Yes, that’s a very important feature since a DST can’t ask for additional funds from the investors, there may be a large amount of reserves in place. In order to protect the investors, those funds can only be invested in short term debt obligations. They can’t be used in any speculative way.
Friant: I guess that is why #5 follows that ruling. The 5th guideline deals with when to distribute the cash that is held.
Kay: Exactly. Any cash other than the reserves, must be distributed to investors in a timely manner. In the DSTs we offer on the www.kpi1031.com marketplace, any potential distributions usually go out monthly to investors.
Friant: That makes sense that the DST can’t just hold on to the funds from the income from the property. The 6th guideline is about capital expenditures can be done in a DST structure with the reserve monies that are being held.
Kay: This is a very important rule. The DST can only make capital expenditures for these three things: normal maintenance and repair, minor non-structural capital improvements, and anything required by law. The DST can’t make major improvements to the properties which is why you typically do not see DST offerings that have a major value add or development component to them.
Friant: I guess that is why a lot of the DST properties tend to be newer assets or those with long term leases. There is only one guideline left and it seems surprising. This rule says that the DST can’t enter into new leases or renegotiate current leases unless the tenant goes bankrupt or is insolvent. How can that work in the real world where a property such as an apartment building may have 300 tenants?
Kay: We do see a number of Triple Net properties in the DST wrapper for that very reason. However, in other cases with operating assets with many different individual leases, there does come a time when a new lease is needed. For this reason, many DSTs have a Master Lease structure where the DST leases to a master tenant who can then enter into new leases or renegotiate existing leases with the underlying tenants.
Friant: Well there you have it. That covers the Seven Deadly Sins for DSTs. Thank you, Dwight for the breakdown into some of the nuances of DSTs.
Kay: You’re welcome. It’s interesting to understand the reasons why a DST is what it is and what is allowed within the structure. Potential investors can read more about DSTs in the book I wrote. They can always request a free copy, either digital or a hard copy at our website. www.kpi1031.com. Thanks, Betty.