Using a Delaware Statutory Trust in a 1031 Exchange

Co-authored by: Diane Abruzzini and Ethan Baldwin

Since 1921, section 1031 exchanges have been one of the most efficient tax deferral and wealth transfer vehicles available for real property investors. In a 1031 exchange, a property owner exits from an investment property and then replaces it with a “like-kind” asset, the benefit being the deferral of capital gains tax from the relinquished property. Notably, Delaware Statutory Trusts (DST) serve as a vehicle that may qualify for a 1031 exchange (DSTs may be used for a straight cash investment as well). DST rules were laid out in The Delaware Statutory Trust Act (DSTA). Rather than having to find a “like-kind” property, an investor with a capital gain, from the sale of real property, can invest the proceeds in a beneficial undivided fractional interest of a DST.

The framers of the trust agreement for a DST set out contractually the rights and responsibilities of the trustees and trustors.[1] The holder of a beneficial interest is treated as owning an undivided fractional interest in the property held by the DST for income tax purposes. The DST is then managed by a sponsor real estate firm. The beneficial interest holders may have little or no say in the management of the properties, depending on the terms of the trust agreement. These types of trusts allow for tax deferral and passive income without having to manage the real estate holdings. The tax advantage has encouraged increased competition in real estate investments, thus spawning real estate development.

A 2004 IRS official Revenue Ruling (Rev. Ruling 2004-86) laid out the structure a DST requires to qualify for a 1031 exchange. The separate legal entity of a DST must own 100 percent of the fee-simple interest in the underlying real estate and may allow up to 100 investors to be beneficial owners. This is larger than the close corollary of the DST– Tenants in Common (TIC) – which the IRS allows only up to 35 investors to participate in. The other difference between a DST and TIC is that a TIC investor owns an undivided pro-rata share of the title property where a DST investor owns a beneficial interest in a trust which in turn, owns the underlying real assets.

There are several benefits to a DST. They often provide a monthly cash flow; they also provide diversification for the investor across geographical regions, asset classes and tenants. The properties are managed by professional sponsors, allowing for passive income coming from core institutional quality real estate. When compared to a traditional 1031 exchange, a DST has more certainty of execution and is generally quicker to close. For investors who are transitioning out of real estate management, a DST can be a useful vehicle to defer capital gains taxes without taking on the burden of managing any new property. Other benefits include the pooling of interest holder resources to support a much larger real estate investment than a single investor could achieve on their own. The trust structure also insulates investors from some liabilities.

Simply because an investment has a potential tax advantage does not inherently make it a suitable investment. Advisors must still be able to identify quality investments for their clients. High quality sponsors are doubly important because of the restrictions around actions the trust may take. For example, if the DST takes any action as a business entity, it can be taxed as such, losing its specific tax advantages.[2] Those criteria are referred to colloquially as the “Seven Deadly Sins”, as follows.

  1. No follow-on investments. Once the offering is closed, the trust is not open to new investors or future contributions by current investors.
  2. Loan terms cannot be renegotiated. Once the offering is closed, the terms of any loans may not be renegotiated by any trustee. The trustee may not borrow any new funds from current investors unless loan default is imminent.
  3. The trustee may not reinvest proceeds from a sale.
  4. Funds held limited to investment options. For delayed or deferred exchanges, the trustee has 45 days to select potential properties for reinvestment. Any funds held in the time between the sale of one investment property and the deployment of the like-kind investment property may only be invested in short-term bonds.
  5. Regular cash distributions. All cash above the necessary reserves must be distributed at regular intervals.
  6. Limited capital expenditures. The trustee is limited in the capital expenditures that can be made. Funds may only be deployed for standard repairs, minor capital improvements, and improvements required by law. Funds may not be deployed for structural improvements, or capital expenditures that exceed a certain level.
  7. Terms may not be renegotiated. The trustee may not enter in any new lease agreements, nor may they renegotiate existing lease terms. For this reason, trustees often create a long-term lease with a property manager. That property manager often enters into multiple lease agreements with tenants, which are not subject to the same restrictions.

There are some intrinsic disadvantages to the DST structure. The sponsor firm, property manager or “trustee” generally runs the show when it comes property management. A DST structure may be impractical for real estate investors who are accustomed to having heavy influence on the property management. DSTs also have long holding horizons between five to ten years; for some investors, this is unsuitable. DSTs are illiquid assets. Also, if the underlying property is not sold after 10 years, the DST must revert to an LLC, which may make it difficult for the investors to carry out a future 1031 exchange. Another restriction is the limitation on raising new capital once the DST offering is closed. Major expenses, like replacing a roof, can quickly eat away several years of DST profits if adequate reserve funds are not available. Unexpected changes in rents and occupancy can similarly reduce cash flows; passive in this case does not necessarily mean safe.

With a number of potential hazards, investors and advisors need transparent insight into a DST sponsor. A high-quality sponsor will structure the trust terms effectively, as these terms cannot be negotiated. And a high-quality DST will not only offer tax advantages to investors, but also appropriate risk-adjusted return on investment as well as diversification. The intrinsic advantage of a DST is that it qualifies for a tax-deferred 1031 exchange, while allowing for investors to pool their resources. For investors selling appreciated property, DSTs provide benefits that other tax-advantaged vehicles do not. With any investment it is important to receive sound advice, this is true for DSTs as well. Being aware of the “Seven Deadly Sins” and steering clear of these pitfalls will greatly increase the likelihood of a successful DST investment.

This publication is a service to our clients and friends. It is designed only to give general information on the developments actually covered. It is not intended to be a comprehensive summary of recent developments in the law, treat exhaustively the subjects covered, provide legal advice, or render a legal opinion. It does not provide that necessary customization of  advice, tailored to a client, which would be provided by an accountant or tax lawyer.  The views and opinions expressed in this article are those of the author’s and do not necessarily reflect the official policy or position of Holdings, Inc.  

[1] Acquisition, Disposition & Structuring Techniques Corner: The Do’s and Don’ts of DSTs (Part I )Matejcak, Peter RLipton, Richard MSteinhause, DarrylCullen, Daniel F.Journal of Passthrough Entities; Riverwoods Vol. 21, Iss. 1,  (Jan/Feb 2018): 11-14,55-56.

[2] Acquisition, Disposition & Structuring Techniques Corner: The Do’s and Don’ts of DSTs (Part I) Matejcak, Peter RLipton, Richard MSteinhause, DarrylCullen, Daniel F.Journal of Passthrough Entities; Riverwoods Vol. 21, Iss. 1,  (Jan/Feb 2018): 11-14,55-56.

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