Investors are often drawn to DSTs, or Delaware Statutory Trusts, as a vehicle for deferring and possibly avoiding paying capital gains tax on the sale of other investment real estate property. Rather than doing a traditional 1031 exchange, from one wholly-owned property to another, a DST allows investors to utilize a 1031 exchange into a DST that is actively managed by an experienced and professional third-party. This allows the investor to take a passive, backseat role rather than own real estate that requires their active management.
Investing in a DST can potentially provide a great, hassle-free way for investors to earn passive income on a monthly basis in a diversified portfolio of institutional-grade real estate.
Yet, just as traditional 1031 exchanges have strict rules, so do DST investments. To clarify the rules and regulations pertaining to DSTs, the IRS (ruling 2004-86) introduced the "seven deadly sins" of DSTs. These rules limit the powers of DST trustees and serve as the compulsory guidelines for how DSTs operate.
In this article, we provide an explanation of each of the seven deadly sins of DSTs.
1. Once a DST offering is closed, no future capital contribution is permitted to the DST by either existing or new investors.
Unlike other types of real estate syndications or funds, once a DST offering has closed, that DST may not request additional contributions or make capital calls from investors. This is because when you invest in a DST, you receive a pro rata share of ownership in the property based on the value of your initial investment. Any future investments could potentially change ownership percentages, and by extension, may dilute someone's ownership share. Doing so would impact investors' claims to the DST assets and therefore, no further contributions are allowed once the DST offering closes.
2. The Trustee of a DST cannot borrow more funds or renegotiate the terms of existing loans.
Prior to accepting investments, the sponsor of a DST is required by law to disclose the loan amounts associated with the property held in that DST. This allows prospective investors to evaluate the debt-to-income ratio of a portfolio during their due diligence process, as the type, rate and terms of the debt can impact investment returns. Since DST investors have very little authority over investment decisions, this ruling prevents the sponsor from assuming more debt or refinancing into a new mortgage that may otherwise impact the beneficiaries' interest.
There is an exception to this rule, however. The DST sponsor may be able to renegotiate loan terms or assume additional debt in the case of a tenant's bankruptcy or insolvency, though not without significant paperwork and oversight.
3. A DST cannot reinvest proceeds from the sale of its real estate.
Unlike REITs, or real estate investment trusts, the IRS prohibits a sponsor from reinvesting proceeds from the sale of the DST into new investment property. Instead, the sale proceeds must be distributed to the DST's various beneficiaries. Those who have invested in the DST can then take their share of the sales proceeds and either roll over the gains into another DST (via a new offering with the same sponsor or another sponsor altogether) using the 1031 mechanism or cash out entirely. Those who elect to do the latter will find that their capital gains are subject to state and federal taxes at that time.
4. The DST sponsor has limited authority to make capital improvements, except for those associated with (a) normal repair and maintenance; (b) minor, non-structural capital improvements, and (c) those required by law.
The IRS limits the scope of improvements any DST sponsor can make. The rationale is that historically, some sponsors have elected to make capital improvements that ultimately put the beneficiaries' investment at risk. This provision is intended to protect investors from ill-fated capital upgrades.
5. Any cash reserves being held between distribution dates may only be reinvested in the DST's short-term debt obligations.
Because DST sponsors cannot raise extra cash or take on new debt after the offering closes, most DSTs have substantial cash reserves on hand. These cash reserves are available to make future investments, if need be. However, to prevent the use of cash in a speculative way (such as unfruitful capital improvements, as noted above), the IRS only allows DST sponsors to invest cash in short-term loan obligations that can easily be liquidated prior to the DST's next distribution date (and therefore, is considered a cash equivalent).
One upshot of this provision is that it allows the DST sponsor to make quick, thoughtful capital improvements that increase the value of the DST without putting the beneficiaries' investment at risk.
6. All cash, other than necessary reserves, must be distributed to co-investors on a regular basis.
A DST is only able to keep "necessary" reserves on hand to cover property management, emergency maintenance or repairs and other unexpected expenses. Otherwise, all cash earnings and proceeds from the sale of DST property must be paid out to investors on agreed upon distribution dates. This "deadly sin" is intended to prevent sponsor misappropriation of funds and helps to ensure that the DST beneficiaries earn their distributions on a regular basis.
7. The DST sponsor cannot renegotiate existing leases or enter into new leases after the offering has closed.
Once a DST has closed, the IRS prevents the sponsor from entering into new leases or renegotiating current leases. This is because lease terms can have a dramatic impact on revenue and therefore, may impact investors' returns.
One "workaround" to this provision, if you will, is for DSTs to use a Master Lease structure. Under a Master Lease, the DST leases property to a "master tenant" who may then enter into new leases or renegotiate existing leases with sub-lessors. The master lease provides DST investors with some certainty, while providing the master tenant with some flexibility to tweak leases for the property's benefit. This ensures the sponsor will not make risky leasing decisions and puts the onus on the master tenant to fulfill the master lease obligations.
The exception to this rule is if a tenant experiences bankruptcy or insolvency, in which case the sponsor may enter a new lease or renegotiate the lease terms for that tenant.
At first glance, it may seem that DSTs are overly regulated. In reality, the seven deadly sins of DSTs were simply enacted to protect investors. These rules must be followed closely by the sponsor and investors alike. Accordingly, investors will want to carefully vet any sponsor prior to investing in a DST. Specifically, look for sponsors who can speak to the seven deadly sins of DSTs with confidence. Their ability to explain the intricacies of these regulations will be a positive sign that the sponsor is highly qualified and able.
If you need help with a 1031 exchange, contact us today. Our team would be happy to walk you through the process of investing your capital gains into a DST. Doing so, investors will find, is a great way to defer paying capital gains tax while simultaneously moving from active to passive real estate investments that are diversified.
Not an offer to buy, nor a solicitation to sell securities. Information herein is provided for information purposes only and should not be relied upon to make an investment decision. All investing involves risk of loss of some, or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing.
1031 Risk Disclosure:
- * There is no guarantee that any strategy will be successful or achieve investment objectives;
- * Potential for property value loss - All real estate investments have the potential to lose value during the life of the investments;
- * Change of tax status - The income stream and depreciation schedule for any investment property may affect the property owner's income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;
- * Potential for foreclosure - All financed real estate investments have potential for foreclosure;
- * Illiquidity - Because 1031 exchanges are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.
- * Reduction or Elimination of Monthly Cash Flow Distributions - Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;
- * Impact of fees/expenses - Costs associated with the transaction may impact investors' returns and may outweigh the tax benefits