What is a "Springing LLC"?
Carl E. Sera, CMT
March 22, 2021
A Springing LLC is a technique that DST sponsors use to convert a DST into before converting back to a DST. While seldom utilized, it is an arrow in the sponsor’s quiver to protect investors typically when an investment has not performed as well as expected and needs attention that DST guidelines do not allow. The expected sequence in these rare occasions is DST to Springing LLC then back to DST then termination of the DST and funds returned to the investor.
While the Delaware Statutory Trust (DST) is an excellent 1031 exchange alternative, it comes with strict guidelines which at times which may tie the hands of the sponsor that wants or needs to add value or make changes. When this happens, and again, it seldom happens, the sponsor acts to protect the investor by converting the DST into a Springing LLC to gain additional flexibility.
One of the goals of any investor is to see that their investments are secure and bring in the required return on investment (ROI). But like any other investments, things can go wrong even when investing in a Delaware Statutory Trust (DST). However, when events turn out the wrong way, it is important that you know what to do to get your investments secure and right on track.
Unlike most real estate investment strategies, the Delaware Statutory Trust has a safety net that protects your investment in the face of a bankruptcy or any other financial issue. And it is known as the Springing LLC. Due to the need for DSTs to be compliant with 1031 exchange rules and regulations, the Delaware Statutory Trust is structured as a passive vehicle for holding real estate thereby limiting the powers of the Trustee.
These limitations are typically referred to as the seven deadly sins of the Delaware Statutory Trust. Some of these limitations include:
- The Trustee of the DST is prohibited from entering into new leases or renegotiating existing leases
- The Trustee is refrained from making any property operating decisions because doing so could jeopardize the tax-deferred status of the Trust’s beneficiaries.
In order to evade the restriction on the powers of the Trustee, DSTs tend to contain a special conversion clause in their operating agreement. The conversion clause is put into action if the Trustee believes and can prove beyond reasonable doubt that the DST is in danger of losing the property due to one structural issue or the other.
In this type of situation, the Trustee can simply convert the DST into a Limited Liability Company (LLC) with all the necessary pre-agreed terms in place. A Springing LLC shares the same form of protection offered by the Delaware Statutory Trust structure but is not limited by the seven deadly sins as seen with DSTs.
That is, the Trustee is not prohibited from raising additional equity, renegotiating existing debt, obtaining new financing, or entering into new leases. In addition, it provides that the Trustee will become the manager of the LLC. The running agreement of the Springing LLC is drafted before the close of the DST to avoid any form of confusion with the rights and procedures after the conversion is carried out.
Furthermore, once a DST is converted successfully to a Limited Liability Company, it will be recognized as a partnership for federal income tax purposes. Among other things, investors in a Springing LLC will not be able to exchange their interest in the LLC in a 1031 exchange when the LLC relinquishes the property.
However, while there are strategies that may allow the LLC to be reconverted into an ownership structure that can be used in a 1031 exchange, there are no guarantees as to what the outcome may be. Nevertheless, the benefit that comes with a Springing LLC surely outweighs the uncertainty that exist with an exit from a DST into a Springing LLC. There is the possibility of protecting the investments, raise new equity, and execute new leases.
While this may seem challenging, keep in mind that the DST structure was created to give tax benefits and other investment benefits to real estate investors. A few hiccups in the structure are just a small inconvenience compared to numerous benefits.
At Sera Capital, we understand the complications that may arise while executing a 1031 exchange, and stand ready to assist you with any questions you may have.