IRS Revenue Ruling 2004-86, which forms the basis for a DST transaction in a Section 1031 exchange program, prohibits seven specific activities by the trustee. This enables a beneficiary to acquire a direct interest in real estate for tax purposes. These restrictions are built into the trust agreement.
The Seven Prohibited Activities
- Once the offering is closed, there can be no future contributions to the DST by either current or new beneficiaries.
- The trustee cannot renegotiate the terms of the existing loans nor borrow any new funds from any party unless a loan default exists as a result of a tenant bankruptcy or insolvency.
- The trustee cannot reinvest the proceeds from the sale of its real estate.
- The trustee is limited to making capital expenditures with respect to the property for normal repair and maintenance, minor non-structural capital improvements, and those required by law.
- Any reserves or 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 trustee cannot enter into new leases or renegotiate the current leases, unless there is a need because of a tenant bankruptcy or insolvency.
Because of these IRS restrictions, the only form of real estate ownership transactions that will work in a DST is a master lease transaction, whereby the master tenant takes on all of the operating responsibilities. The sponsor will also attempt to mitigate against the effect of these seven prohibitions (above) by:
- Acquiring only new or recently rehabilitated Class A properties;
- Raising substantial funds for capital reserves in the offering;
- Having financing terms which go out 7 to 10 years, but less than the term of the master lease; and
- Planning for the sale of the mortgaged property prior to the maturity date of the loan.
The Springing LLC
The solution to give the lender comfort against the DST’s inability to act if the loan is endangered is to place a “springing LLC” provision in the trust agreement. It can be made operative if the trustee determines that the DST is in danger of losing the mortgaged property because of an actual or imminent default on the loan, and because tax-related restrictions – the seven prohibitions – are preventing the trustee’s ability to act. Delaware law permits conversion by what is basically a simple election, which does not constitute a transfer under Delaware law.
This “springing LLC” will contain the same SPE and bankruptcy remoteness provisions as the DST (for the lender’s benefit), but it will permit raising additional funds, new financing or renegotiation of the terms of the existing financing, and the renegotiation of leases. In addition, it will provide that the trustee or sponsor will become the manager of the LLC with full operating control.
A DST borrower with a master tenant owned and controlled by a quality sponsor should be an attractive borrower for a lender, and various financing sources have embraced the DST structure. A steady market has been developing for DSTs because they are much less complex than a typical TIC transaction, they shield investors from liabilities with respect to the mortgaged property, and they remove the investors from involvement in operation of the property.