The ABC’s of DSTs
March 11, 2022
By Ken Weissenberg
Real estate owners looking to sell existing real estate and acquire new real estate will commonly explore the use of a 1031 exchange to defer taxation on gains recognized from the real estate that is sold. However, there are several stringent requirements that need to be considered to accomplish a successful 1031 exchange, including the identification and acquisition of replacement property.
Delaware Statutory Trusts (“DSTs”), which are increasingly being used in structuring Internal Revenue Code Section 1031 exchanges (“Sec. 1031 exchanges”), provide some flexibility and options for sellers of real estate. This article will explore what a DST is and how it operates in Sec. 1031 exchanges.
A. DST Basics
A DST is a trust formed and governed under Delaware law. It is created by filing a Certificate of Trust with the Delaware Division of Corporations. A trust agreement needs to be drafted to govern the rights and responsibilities of both the trustees and beneficiaries. Under the trust agreement, the trustee may be given very broad authority to conduct business on behalf of the trust or granted very limited powers.
The DST is treated as a separate legal entity. The creditors of beneficiaries have no right to obtain property belonging to the trust, and the beneficiaries have limited liability similar to corporate shareholders. The rights of the trustee are generally limited to the collection of rent or sales proceeds and the distribution of the net cash to the beneficiaries. The trust must distribute its net cash flow less reasonable reserves at least quarterly.
Generally, when a DST is used to hold real property in furtherance of Sec. 1031 exchanges, the trust has very specific terms and structure. The trust must be treated as an investment trust and not as a business trust for the trust interests to be treated as qualified property for a Sec. 1031 exchange. The IRS refers to the following seven powers that would cause the trust to be treated a business trust and not as an investment trust in Revenue Ruling 2004-86:
- No additional capital contributions are permitted after the DST offering is closed.
- The trustee cannot refinance or renegotiate the existing loan or place new debt on the property.
- The leases on the property cannot be modified or a new lease entered into unless the tenant is insolvent or in bankruptcy.
- All cash less reserves must be distributed at least quarterly.
- Reasonable reserves retained by the trust must be held in short-term investments or government securities.
- Capital expenditures are limited to normal repair and maintenance, non-structural improvements or to bring the property in compliance with legal requirements.
- Sales proceeds cannot be reinvested.
These rules were relaxed somewhat under Rev. Proc. 2020-34, which provided COVID relief through the end of 2020. Under that limited relief, trustees were permitted to modify existing loans and leases and accept additional cash contributions.
B. Use in Sec. 1031 Exchanges
Assuming the DST is structured to qualify as an investment trust under Rev. Rul. 2004-86, the owner of an interest in the DST is treated as an owner of a grantor trust that is disregarded for federal income tax purposes. As such, the owner is treated as owning a proportionate share of the assets and liabilities of the DST. Accordingly, the real property held by the DST would meet the requirements of like-kind property and qualify as replacement property for a Sec. 1031 exchange.
Typically, the real estate is acquired by the trust, while the sponsor of the DST is the owner of all the interests in the trust. The trust units are then sold by the sponsor to investors as replacement property used to complete their Sec. 1031 exchanges or as outright investments. The rights to income and deduction transfer to the unit holders starting with their closing dates. Their percentage ownership is fixed and does not change on the sale of additional units to other investors.
There is a diverse range of properties held by DSTs such as large corporate headquarter buildings, distribution centers, warehouses, apartment buildings and retail establishments. DSTs are similar to tenancy-in-common ownership (“TIC”), but there are certain significant differences. TIC ownership is also restricted in the rights and obligations of each owner. However, unlike a DST, a TIC owner can directly transfer a portion of the property held as a TIC. The TIC owners must act unanimously to deal with decisions involving the operations of the property, whereas in a DST, the trustee acts on behalf of the trust. To get IRS approval to be treated as a TIC, and not a partnership, the TIC can have no more than 35 owners. There is no limit on the number of DST owners. Accordingly, DSTs tend to own larger assets than TICs.
C. Tax Reporting
The owner of an interest in a DST generally receives a grantor trust letter from the DST that has information necessary for the DST owner to report their share of the property’s income and expenses. Items of income or deduction that may be treated differently by each owner, such as interest expense, are reported separately.
Since the deduction for depreciation is based on each individual owner’s tax basis because of the deferral of gain under the Sec. 1031 exchange, the DST does not provide depreciation deductible by the DST owners. The DST may, however, provide the percentage of the classification of assets for depreciation purposes such as land, building, land improvements and personal property. Each investor must report both the Sec. 1031 exchange as well as the income and deductions arising from their DST ownership on their own appropriate tax forms.
DSTs are becoming more popular for investors engaged in Sec. 1031 exchanges. They provide an interesting alternative to direct ownership of replacement property in Sec. 1031 exchanges. Because there are certain time limitations for a taxpayer looking to acquire like-kind property in a Sec. 1031 exchange, acquiring an interest in a DST may be a viable alternative. Moreover, for taxpayers looking to sell real estate, structuring a DST as a sponsor may open up an additional market of buyers.