By Alex Madden, Vice President with Kay Properties and Investments
There is a lot to read and learn about DST or Delaware Statutory Trust investments and 1031 exchanges. First let’s begin with the basics. What is a DST 1031 Property? A DST is an entity with which investors can hold title to investment real estate. A structured DST property qualifies as like kind exchange property for a 1031 exchange.
But there are many more facts about investments, specifically DSTs. Upon speaking with many investors, we’ve found that they are often interested to learn about these five niche DST facts:
DST Fact Number 1:
IRS Revenue Ruling 2004-86: DSTs had been used for 1031 exchanges for many years prior to the IRS Revenue Ruling in 2004, but after ruling 2004-86 the IRS provided specific guidance on the use of DSTs in 1031 exchanges, thus providing authorization for DST exchanges when IRS guidance is met. It stated that for a 1031 exchange, beneficial interests in a Delaware Statutory Trust investment would be treated as replacement property as long as seven key criteria were met. These are mentioned in the Revenue Ruling 2004-86 and are referred to as the “Seven Deadly Sins”. It further held that the DST must be a passive holder of real estate, placing restrictions on the trustee of the DST – the restrictions are covered in the facts about DST pertaining to the Seven Deadly Sins.
DST Fact Number 2:
Springing LLC: Under certain circumstances a DST can be converted into an LLC. Certain limitations are provided on what a DST can and cannot do. In the event that proactive steps are required to prevent a Delaware Statutory Trust investment from significant loss a DST can convert into an LLC to take steps which a DST cannot. Examples include: renegotiating existing debt, obtaining new financing, and entering into new leases. Once a DST is converted to an LLC it could potentially be treated as a partnership for federal income tax purposes and investors could potentially lose the ability to 1031 exchange their property in the future. Understandably, the Springing LLC is generally regarded as a safety net to potentially protect the property if there was a negative situation. In the hundreds of DST offerings that Kay Properties has participated in we have only seen the springing LLC utilized by DST sponsor companies a handful of times however it is nice to have it available as a safety net for the property and investors.
DST Fact Number 3:
UPREIT: An umbrella partnership real estate investment trust (UPREIT) uses the 721 Exchange as opposed to the 1031 Exchange to contribute a DST to a REITs operating partnership (OP) on a tax deferred basis in exchange for OP units. As such an UPREIT is subject to the Internal Revenue Code (IRC) Section 721 exchange.
This is one possible exit strategy for DSTs. Investors are often provided a choice as to whether they would like to participate in the UPREIT using the 721 exchange, or go their own way using the 1031 exchange into more Delaware Statutory Trust investments or into another property they would manage on their own. If they opt for a Section 721 exchange into an UPREIT, the property owner can receive the value of the property in the form of UPREIT units.
Although the Section 721 exchanges into an UPREIT are not taxable, the REIT taxation rules apply. Besides utilizing DSTs for tax deferments or gains, investors can also consider opting for an UPREIT as it’s another great option for those wanting to sell their property, be it individual or commercial property owners.
DST Fact Number 4:
7 Deadly Sins – Here are a few interesting investment facts for those of you considering investments in DSTs – In order to meet IRS guidance a DST must avoid the following:
- No future contributions: Once a DST offering is closed there can be no additional contribution of capital by either current or new investors.
- Restrictions on Debt: The Trustee cannot renegotiate existing debt terms or initiate new secured loans from any party. Some exceptions apply. This is one reason why many investors prefer to invest in debt free DSTs.
- No reinvestment of proceeds: The choice of where to reinvest is retained by individual investors when the real estate is sold.
- Required Distributions: With the exception of reserves, all cash received by the DST must be distributed to investors.¹
- Limited Capital Expenditures: The Trustee may only have capital expenditures to cover the following:
- Normal repair and maintenance
- Minor non-structural capital improvements
- Those required by law
- Restrictions Investing Reserves: Any cash retained by the Trustee for reserves or between distributions dates may only be invested in short-term debt obligations.
- Restrictions on Leases: The Trustee may not renegotiate, or enter into a new lease. Some exceptions apply.
DST Fact Number 5:
Lower Minimum Investments: Due to the higher number of contributing investors allowed into the DST structure (typically capped at 499 compared to 35 in the TIC 1031 structure) there is typically a lower dollar contribution minimum. Minimum investments are set by the DST sponsor company of the Delaware Statutory Trust investment offering. The minimum investments are often either $25,000 or $100,000.