How does a 1031 DST work?
The 1031 DST has become a go-to structure for commercial real estate owners looking to capture the benefits of a tax-advantaged investment – without the hassle of actually maintaining a property.
Section 1031 of the federal tax code allows an investor to defer capital gains taxes by using profits on the sale of an investment property to buy another similar property. This “exchange” of properties is enhanced for many investors by a Delaware Statutory Trust (DST). The DST allows the investor to buy a fractional interest in commercial real estate, and capitalize on income from the property, appreciation and any other tax benefits that may occur.
Under Internal Revenue Service rules, investors have no voice in the active management of the trust’s property. Management falls to the trust itself, which usually turns over day-to-day responsibilities to a master leaseholder or property manager. With minimum investments of $50,000 to $100,000, DSTs can allow smaller commercial real estate holders a chance to trade in their holdings to buy into large-scale investments previously only available to institutional investors and to potentially diversify across asset types or geographic focus.
During the last decade, DSTs have essentially taken over the securitized 1031 exchange market. In 2018, the latest year for which data has been compiled, more than 90 percent of all transactions in the market were DSTs.
Several DST Benefits for Lenders
The classic example of a 1031 DST is one of the retirees looking to get out of the business of day-to-day management of their rental homes or apartment buildings. For them, a DST exchange means deferred capital gains, rewards from investing in collectively owned commercial property, and no renters or maintenance.
To a financial institution, however, a 1031 DST—at least on the surface—may seem like a recipe for confusion. After all, what lender wants to deal with the whims and desires of dozens of owners of a property or set of properties?
The good news for lenders is that under Delaware law, a DST is a separate legal entity. Unlike, say, a tenancy-in-common, where multiple property owners might be listed on a loan, a DST has one borrower – the DST itself.
Even better for the lender, the IRS has strictly limited the role investors can take in the operation of the property (or properties) held in trust. Beneficial interest-holding investors only have a right to distributions from the trust. The signatory trustee is the sole party authorized to act on behalf of the DST with a secured lender.
Delaware law also brews greater stability into the structure of the trust than some other commercial real estate investment structures. In those, property and asset management agreements are renewable each year. Not so with a DST. The signatory trustee is not on an annual contract and, in most cases, is the lender’s sole contact for the life of a loan. The law also requires the trust to have a separate Delaware trustee, which can prevent the trust from inadvertently terminating or undertaking an action that could jeopardize the preferential tax treatment.
Limited Interaction with the Property
The owners who have invested in a DST are taking advantage of a Section 1031 tax-deferred exchange—replacing their own real estate with the property owned by the trust. To ensure their investments constitute a valid replacement under IRS rules, the trust’s actions regarding the property must be extremely limited.
The trust, for instance, can make no future contributions to the cash or equity of the trust once closing on a property has occurred. It cannot take on new debt or renegotiate loans, except in the limited circumstances of a tenant’s bankruptcy. Capital spending is largely limited to normal repairs and maintenance. And the trust cannot renegotiate leases or enter into new ones, unless, again, the tenant is in bankruptcy.
These restrictions only apply to the signatory trustee. They do not, however, apply to a tenant under a long-term lease. That’s why most DSTs utilize a master lease agreement arrangement where the lessee is owned by the sponsor of the real estate transaction. The master lessee is then able to manage the property in ways a signatory trustee cannot. These leases are fully subordinated to the loan on the property, and the lessee is structured as a single-purpose entity with customary separateness covenants.
For investors and lenders, the structure is a win-win. The trust’s role is, by law, extremely curtailed, giving investors the full tax benefits that a 1031 DST has to offer. Meanwhile, lenders are able to count on a solidly structured entity, with a single point of contact and low risk that loan terms may need to be altered in the future.
A Continuing Evolution of DSTs
The 1031 DST was still a relatively new concept prior to the Great Recession a decade ago. IRS guidance on the structure was issued in 2004 under Revenue Ruling 2004-86. Most pre-recession investors interested in fractional ownership were placed in tenancy in common (TIC) syndications.
But as lenders and investors have learned, a TIC can be fractional and fractious as well. Each owner must sign off on decisions, and in many cases, unanimous approval is required. When a crisis like the Great Recession occurs, a TIC structure can become unwieldy and magnify risks. 1031 DSTs, with reliance on the signatory trustee as the voice of the trust, have helped address some of those issues. And in the years since the recession, DSTs have become the dominant structure used by most sponsors.
Still, certain aspects of DST-related transactions continue to evolve. Recently, for instance, sponsors have been seeking to have deals structured with back-end agreements that are more like those in private equity – particularly where disposition fees are concerned.
Disposition fees are usually charged by investment advisers for their services in a real estate transaction. Some sponsors are looking for disposition fees that are subject to the return of capital requirements or are asking for tiered disposition fees subject to return thresholds.
By recapturing fees in this way from the proceeds of a property sale and from rental payments, the sponsor is looking for a way to reduce its tax burden. This represents a more aggressive tax position than in previous deals where disposition fees have been, in general, free of such claw-back provisions, because a sponsor and DST are not allowed to share profits.
Such nuanced shifts in tax avoidance and transactional strategy require experienced advisers to ensure that they will survive scrutiny from regulators. Kaplan Voekler Cunningham & Frank is deeply engaged in all facets of real estate syndications, including 1031 DSTs, and works closely with developers and owners, private equity funds, government agencies, investment banks, and other institutions. To learn more about how we can help, contact us for a consultation.