The concept of the “Seven Deadly Sins” of a Delaware Statutory Trust (DST) refers to specific activities that a DST sponsor must avoid to maintain the trust’s tax-advantaged status under IRS Revenue Ruling 2004-86. These restrictions are crucial for ensuring the DST qualifies for 1031 exchange purposes. In some ways, these rules force sponsor transparency and limit the opportunity for a sponsor to mismanage an asset. However, it can also be restrictive, limit upside potential, and pose challenges for certain investments. Below is a critical examination of these seven prohibitions:
1. No Renegotiation of the Terms of Existing Loans or Entering into New Loans
A DST cannot renegotiate existing loan terms or enter into new financing arrangements. This restriction helps maintain the passive investment status required for 1031 exchanges. However, investors may miss opportunities to refinance at lower interest rates and potentially increase cash flow. Additionally, DST properties may be forced to sell when the loan matures, even if the property market is down or the asset is experiencing temporary challenges, potentially leading to a loss. In these situations, other syndications that allow refinancing, such as Tenants-In-Common (TIC), may be preferable.
2. No New Leasing or Renegotiation of Leases
DSTs are prohibited from entering into new leases or renegotiating existing ones. This poses a challenge for properties with frequent lease turnovers, such as multifamily units or self-storage facilities. Sponsors often circumvent this restriction by creating a subsidiary that enters into a “Master Tenant Lease” with the DST. This sponsor can then negotiate “subleases” freely. However, this often leads to a complicated legal structure with uncertain cash flow strategies and potential hidden tax implications.
3. No Major Capital Expenditures
DSTs cannot make significant capital improvements or repairs beyond normal and routine maintenance. Major expenditures could alter the nature of the investment and disqualify it from 1031 exchange benefits. While this rule enforces a conservative business plan, it may not appeal to investors seeking higher potential returns. These investors may prefer entities like TICs to meet their investment objectives.
4. No Reinvesting Proceeds from Property Sales
If a DST sells a property, the proceeds must be distributed to investors rather than reinvested in new property. This prevents changes in the investment portfolio that could jeopardize the DST’s tax status. However, challenges arise when a DST has multiple properties. If a sponsor sells part of the DST’s portfolio, it may force investors to either conduct multiple small 1031 exchanges or pay taxes. A sponsor’s intention is typically to sell the entire portfolio at once, but if it fails to do so, it can result in a complicated tax situation.
5. Excess Reserves Must be Distributed to Investors
DSTs can maintain only limited reserves for property operations, typically up to 3% of the property’s value, intended for normal maintenance and operations. These reserves cannot be used for significant improvements or changes and must be placed in conservative short-term investments. Excess reserves must be distributed to investors. This rule creates more transparency and accountability, which will benefit the investors. However, sometimes, the sponsor needs to build up cash reserves if it anticipates economic challenges down the road.
6. No Business Operations
A DST must avoid any active business operations, limited to collecting rent and paying operating expenses related to the property. Engaging in business activities could change the DST’s nature, affecting its eligibility for 1031 exchanges. Therefore, cash reserves can only be held in cash, used for property expenses, or distributed to investors. This may prevent the sponsor from mismanaging the cash by making poor or irresponsible investments.
7. No Future Capital Contributions
Investors cannot make additional capital contributions to the DST after their initial investment. This ensures the investment remains static and prevents modifications that could alter the trust’s nature. The inability to conduct a capital call without risking the 1031 exchange eligibility requires sponsors to maintain substantial reserves, which may be taxable and restricted to property expenses. Some investors prefer entities that allow capital calls, enabling investors to inject additional capital when needed while keeping initial funds invested elsewhere. Removing the requirement for substantial reserves also mitigates the chance of the reserve fund triggering a small tax consequence.
Conclusion
By adhering to these restrictions, DSTs maintain their passive investment status, making them eligible for 1031 exchanges and allowing investors to defer capital gains taxes while investing in real estate. Prospective 1031 exchangers seeking a passive investment should carefully review the structure of their investment options to ensure alignment with their goals and risk tolerance.
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1031 Exchange Risk
Internal Revenue Code Section 1031 (“Section 1031”) contains complex tax concepts and certain tax consequences may vary depending on the individual circumstances of each investor. RM Securities and its affiliates make no representation or warranty of any kind with respect to the tax consequences of your investment or that the IRS will not challenge any such treatment. You should consult with and rely on your own tax advisor about the tax aspects with respect to your particular circumstances.Please note that RealtyMogul does not provide tax advice.
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