If you are reading this, it’s probably because you have already reached the point where you understand that perhaps A DST or Delaware Statutory Trust may be an excellent vehicle to defer and possibly avoid the 4 taxes associated with the sale of real estate. Not only do DSTs allow investors to earn hassle-free monthly income, they also eliminate the stress of managing rental property and offer the potential to diversify and upgrade your real estate portfolio. Like all good things, the DST comes with a price or a set of rules that the sponsors of these vehicles must follow. It will serve the reader well to understand what we call the seven deadly sins of DSTs. Why? Because when you invest in a DST, not only must the sponsor follow these rules but so will the investor. They were designed to make a DST resemble real property as much as possible and is why for example—you can’t 1031 into either a public or privately traded REIT.
To prevent the misuse of power by the appointed Trustees, the IRS (ruling 2004-86) introduced the seven deadly sins of DST that limits the powers of trustees. These seven deadly sins act as a compulsory guideline for both the trustees and beneficiaries of a DST. Below is a detailed explanation of the seven deadly sins of DST.
1. Once A DST Offering Is Closed, No Future Equity Contribution Is Permitted To The DST, Either By Current Or New Beneficiaries.
When you invest in a DST, you receive a certain percentage of ownership based on the value of your initial investment. According to the IRS ruling, once the initial capital investment offering is closed, the trust manager cannot request contributions from the existing beneficiaries or organize a new capital call for investors.
This is because if the Trustee accepts additional capital contributions to the DST after the close of its offering, your ownership percentage may be diluted thereby affecting your claims to the DST assets.
2. The Trustee Of The DST Is Restricted From Borrowing Any New Funds Or Renegotiating The Terms Of The Existing Loans.
Once you decide to invest in a DST, it is required by law that the sponsor disclose the loan amounts associated with the DST. Part of the due diligence you should do is to understand the loan amounts of the DST and how they impact your investment returns. Please note, these loans are non-recourse which means that the DST investor is not liable for any loans within the DST they purchase. In this regard, DSTs function more like limited partnerships and limits the financial responsibility of the investor to their initial investment.
Since DST beneficiaries are limited in their right to dictate the operations of the DST, this ruling prevents sponsors from assuming more debts or refinance into a new mortgage because it may cause a serious impact on beneficiaries’ interest.
3. The Trustee Is Not Allowed To Reinvest The Proceeds From The Sale Of Its Investment Real Estate
Once a DST is sold, the IRS prohibits the sponsors from reinvesting the proceeds from the sale of the DST into a new investment real estate. This makes a DST very different from a REIT. The ruling stipulates that the sale proceeds must be distributed to the various beneficiaries. In a nutshell, the sponsors have no right to withhold or reinvest the proceeds without the knowledge of the beneficiaries.
If you had invested in a DST, you have the option of 1) “rolling over” into another DST through the 1031 mechanism, or 2) completely or partially cashing out of the DST. Of course, any amount you do not “rollover” is subject to the various federal and state taxes.
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.
While Trustees are allowed to carry out minor structural improvement or maintenance of the property, the IRS restricts sponsors from making any capital property upgrades that may put beneficiaries’ investment at risk. This DST deadly sin protects the investment of beneficiaries from being used in ill-fated capital upgrades.
5. Any Liquid Cash Held In The DST Between Distribution Dates Can Only Be Invested In Short-Term Debt Obligations
Since DST sponsors are not allowed to raise extra cash or funds after the offer closing date, there is usually a reserve of cash available for additional investment. To prevent the use of these cash reserves in a speculative way, the IRS only allows for DST sponsors to invest in short-term loan obligations that can easily be converted to cash before the agreed distribution date.
One of the upsides to this rule is that it allows DST sponsor to increase the value of the DST on behalf of the beneficiaries without causing any risk.
6. All Cash, Other Than Necessary Reserves, Must Be Distributed To The Co-Investors Or Beneficiaries On A Current Basis
According to the IRS regulations, DSTs are allowed to keep cash reserves on hand to cover emergency maintenance and repairs issues. However, they are required to share the earnings and proceeds realized from the DST to its beneficiaries within the agreed distribution date. This deadly sin prevents trustee misappropriation of funds and protects beneficiaries’ rights to receive their earnings promptly.
7. The Trustee Cannot Enter Into New Leases Or Renegotiate The Current Leases
DSTs work great with a long-term lease to creditworthy tenants under a triple-net basis. Since the IRS prohibits DSTs from entering new leases or renegotiating their current lease, most DSTs employ the use of a Master Lease Structure.
Under the Master Lease Structure, the DST leases the property to a master tenant who is charged with the responsibility of entering new or negotiating existing leases. The upside to this deadly sin is that it prevents the Sponsor from entering new leases or changing the terms of the DST structure. However, the IRS allows for an exception in the event of a tenant bankruptcy or insolvency.
We hope this post answers some questions with regard to investor rights and DST design. In a nutshell, the DST is an option for those that want to defer and potentially avoid taxes by the use of a 1031 exchange but no longer want to utilize the 1031 exchange into real property but instead into securitized property.
The question then becomes-what’s the best DST or portfolio of DSTs available and how do I choose which one or ones to purchase and in what quantities. To learn more visit our page on Delaware Statutory Trusts and 1031 Exchanges or Delaware Statutory Trust Fees and Commissions.