The Delaware Statutory Trust offers 1031 alternative for group investors.
During the past decade, many investors have taken advantage of Internal Revenue Code Section 1031 tenancy-in-common exchange strategies. The TIC concept permits small to midsize accredited investors to own and obtain title to professionally managed, potentially institutional-quality real estate. Most TIC investors have implemented this strategy to serve as replacement property to satisfy their 1031 exchanges. However, in today’s turbulent economic environment, a lesser-known 1031 exchange replacement property alternative, the Delaware Statutory Trust structure, currently is growing inpopularity among investors.
DSTs are separate legal entities created as trusts under Delaware statutory law that qualify under Section 1031 as tax-deferred exchanges. According to Revenue Ruling 2004-86, which supports DSTs, the DST owns 100 percent of the fee interest in the underlying real estate. DSTs generally allow up to 100 or more investors, which may include 1031 exchange investors or traditional direct investors. The real estate sponsor that organizes and manages the deal also usually serves as the DST’s managing trustee. The investors own a beneficial interest in the trust, which owns a fee-simple interest in the underlying real estate
DSTs Rise as Credit Markets Fall
One of the main reasons the DST structure has gained so much steam among 1031 exchange investors and sponsors is due to the tightening credit markets. Under the DST structure, property lenders can make one loan to one borrower — the DST. Unlike other TIC structures, which permit up to 35 investors who each have to qualify for their own pro-rata share of the mortgage, the DST structure usually affords lenders greater security because they issue just one loan to the sponsor who operates the property.
With the tighter lending restrictions put into place during the past year, DSTs have become much more attractive structures for both sponsors and lenders. However, the structure has clear advantages and disadvantages for investors.
From the investor’s standpoint, the DST composition has several benefits. For example, the IRS revenue ruling that supports the legalities of the structure to qualify as 1031 exchange replacement property allows investors to defer 100 percent of capital gains tax liability upon the investment property’s sale.
Another advantage is that small to midsize accredited investors — individuals whose net worth exceeds $1 million and/or annual income exceeds $200,000 — can own an interest in a professionally managed, potentially institutional-quality asset. Generally these are properties that investors could not otherwise afford to purchase on their own. Accreditation for entities is total assets of $5 million and/or each entity member must qualify as an individual accredited investor.
In addition, unlike the TIC structure’s 35-investor limit, DSTs may permit up to 100 or more investors. This ultimately allows for lower minimum investments — sometimes in the $100,000 range.
However, perhaps one of the most prominent advantages of the DST structure in today’s market is its ability to qualify for attractive financing terms. For example, if an investor who recently sold a $500,000 property ($250,000 in equity and $250,000 in debt) wants to execute a 1031 exchange, he would need to purchase $500,000 or more to satisfy the exchange requirements. The investor could either add more cash to purchase a replacement property of $500,000 or more or try to obtain a mortgage of $250,000 during this tight lending market, which could be extremely difficult. But a third option exists: The investor could fit under the DST umbrella and receive the pro-rata mortgage pass-through of generally 50 percent or more loan to value. In this case, the investor could place $250,000 into the DST (or DSTs) and purchase at least $500,000 of property to satisfy the 1031 exchange, deferring 100 percent of capital gains tax liability.
Risks to Consider
Like all real estate investments and structures, there are risks to assess. DSTs are subject to all related risks associated with real estate ownership, including debt service payments and vacancy rates among others. Perhaps the biggest drawback of the DST is its passive nature for investors. Unlike a TIC where each investor has an equal voting right as to when to sell or refinance, the DST’s master tenant or sponsor takes over these duties. DST investors are limited to a more back-seat role than they otherwise would have under a sole-ownership property or even a TIC structure.
In addition, to qualify for favorable tax treatment, the DST’s trustee is not allowed to take any of the following actions, often referred to as the “seven deadly sins.” The trustee cannot
•?dispose of the trust’s property and then acquire new property;
•?enter into new leases;
•?renegotiate a lease with an existing tenant;
•?accept additional capital contributions from existing investors;
•?renegotiate any existing debt or borrow additional funds;
•?invest the DST’s money in anything other than short-term government obligations; and
•?make more than minor, non-structural modifications to the trust’s property not required by law.
Despite these drawbacks, DSTs are becoming a more prevalent investment vehicle for baby boomers and seniors during the current economic slowdown. The ability to diversify one’s real estate investment holdings into several properties around the country and not have to worry about day-to-day management headaches makes a compelling case as to why DSTs are a wise choice. And, for investors seeking tax deferral via a 1031 exchange or simply a non-correlated asset from the stock market with a relatively low minimum investment, DSTs may be ideal structures to consider.