What Are Delaware Statutory Trusts?
A Delaware Statutory Trust (DST) is a legally recognized trust, used in a variety of transactions and structures. Its flexibility of operation and management, plus the limited liability granted to beneficial owners, have made the DST a popular vehicle for a wide array of business purposes.
In accordance with I.R.S. Revenue Ruling 2004-86, beneficial interests in a Delaware Statutory Trust may be considered “like-kind” replacement property in a Section 1031 or Section 1033 exchange. Title to property is held by the trust as a separate legal entity for the benefit of a beneficial owner, rather than directly, affording liability protection to the owners. Interests in the DST are considered securities under federal securities law, however, they retain treatment as ownership in real estate.
For exchange purposes, DSTs are 100% passive, turn-key investments offered by nationally reputed real estate management companies, referred to as “sponsors.” Sponsors perform the initial due diligence, structure the property acquisition, maintain and lease the property, collect rent, service the mortgage and eventually sell the property. A DST may own one or more properties across diverse asset classes: multifamily residential real estate; net leased retail; medical office portfolios; industrial property, among others.
If leverage is used to purchase the property, the trust serves as the borrower under a non-recourse loan, yet the owners enjoy the benefits of this debt with no effect on credit ratings. Net cash flow from operations, if any, is distributed on a pro-rata basis to the owners, as are depreciation pass-through and interest deductions.
Delaware Statutory Trusts:
- Can be purchased in any dollar amount (within limits), facilitating the “equal and up” replacement requirements for full tax deferral under §§1031 and 1033;
- Allow the investor to own a fractional interest in large, institutional quality and professionally managed commercial property;
- Act as single borrower of any debt, eliminating the need to underwrite individual investors;
- Produce tax-favored, passive income potential, which becomes tax-free when offset by unused passive losses
- Provide asset and liability protection;
- Allow for low minimum investment amounts, providing the opportunity for diversification into several DSTs.
What Are Delaware Statutory Trusts?
In order for a DST to be treated as a grantor trust and qualify as direct interest in real estate for exchange purposes, the IRS has set forth parameters that must be met, pursuant to Rev. Proc. 2004-86, known as the “7 Deadly Sins”:
- Once the offering is closed, there can be no future capital contributions to the DST by either current or new beneficiaries.
- The trustee cannot renegotiate the terms of the existing mortgage loans nor can it obtain any new mortgage financing from any party except where a property tenant is bankrupt or insolvent.
- The trustee cannot enter into new leases or renegotiate existing leases except where a property tenant is bankrupt or insolvent.
- The trustee cannot reinvest the proceeds from the sale of its real estate.
- The trustee is limited to making the following types of capital expenditures with respect to the property:
(a) expenditures for normal repair and maintenance of the property,
(b) expenditures for minor non-structural capital improvements of the property, and
(c) expenditures for repairs or improvements required by law.
- Any cash held between distribution dates can only be invested in short-term debt obligations.
- All cash, other than necessary reserves, must be distributed on a current basis.
The typical trust agreement provides that if the Trustee determines that the DST is in danger of losing the property due to its inability to act because of these parameters, it can convert the DST into a limited liability company (referred to as the Springing LLC) with pre-existing agreed-upon terms.
The laws of the state of Delaware permit the conversion to a limited liability company through a simple filing with the office of the Secretary of State. In a conversion, the Springing LLC is treated as the same entity as the DST. This means that, for purposes of Delaware state law, there is no real estate transfer or change in the borrower. The operating agreement for the Springing LLC will contain the same Special Purpose Entity (SPE) and bankruptcy remoteness provisions that are contained in the DST’s trust agreement. However, it will not contain the prohibitions against the
“seven deadly sins” and thus will permit the raising of additional capital contributions, the raising of new financing, the renegotiation of the terms of the existing financing, or entering into new or modified leases. In addition, it will provide that the trustee (or sponsor) will become the manager of the Springing LLC.