Delaware Statutory Trusts for 1031 Exchanges

We’ve written in another article about how 1031 exchanges provide taxpayers the opportunity to defer taxes due upon the transfer of a property. We’ve also discussed how tenancy in common structures can sometimes facilitate 1031 exchanges. Here, we discuss another approach, the use of Delaware statutory trusts.

Several significant challenges exist for successfully completing a like-kind exchange under Section 1031 of the Internal Revenue Code.

Like-Kind Exchange Challenges

• Finding suitable replacement property
• Performing the due diligence on the property
• Securing bank financing to replace the amount of debt on the original property
• Identifying the property within 45 days
• Successfully closing on the purchase within 180 days
• A sole-ownership property would most likely still require the owner to be a hands-on property owner, since contracting out property management in such cases may be too expensive or impractical
• Interests in a limited partnership or limited liability company do not qualify for 1031 exchange treatment

In certain circumstances, beneficial owners of a Delaware statutory trust (DST) that owns real estate will be treated as owning a direct interest in such real estate for purposes of Section 1031. This determination will be very fact-specific, but generally requires the following:

The trust must be for the protection of beneficiary property, with no power for the manager to vary the trust’s investments.

This point is crucial; the manager/trustee must have very limited powers; in the real estate context, this means that it can NOT:

• Dispose of, or acquire new, property;
• Renegotiate leases;
• Enter into new leases;
• Renegotiate debt obligations;
• Receive capital contributions from investors;
• Invest cash remittances; or
• Make more than minor, non-structural modifications to a property that are not required by law

Master leases must be true leases and not forms of financing

The lessor must make a minimum, unconditional “at risk” investment in the property that remains throughout the lease term. No member of the group of sub-lessees may have an option to purchase the underlying property at less than its then-current fair market value. No member of the group of sub-lessees may make acquisition loans or guarantees. The lessor must expect to make a profit from the transaction (apart from tax deductions and credits).

The owners must be treated as “grantors” of the trust

Owners cannot transfer cash to the trust for reasons other than for a purchase of an interest therein.

The trust must be recognized as an entity separate from the beneficial owners

Creditors of beneficial owners in a DST cannot assert claims directly against the property held by the DST; those owners are entitled to the same personal liability limitations from the DST’s actions as apply to a corporation’s stockholders; a DST may sue or be sued as an entity, and can be formed for investment purposes. These powers and privileges have led the IRS to conclude that a DST is an entity separate from its owners for Code purposes.

There are other requirements, but a properly structured DST generally meets those. If all the requirements are met, then, as “grantors,” owners of a DST should be treated as owning an undivided fractional interest in each of the underlying properties and thus eligible for 1031 exchanges.

There are clearly some drawbacks to DSTs that make them unsuitable for some 1031 exchanges.

Potential Drawbacks to DSTs

Truly Passive Investment.

The pre-packaging, trust structure, and property management limitations makes a DST a truly passive investment with very limited input from investors.

Long-Term Holding Periods.

These investments are usually designed for long-term holding periods, usually 5-10 years; a DST is thus not suitable for an investor who just wants a place to temporarily “park” his money while waiting for some other investment to come along.

Potentially Lower Returns.

Individual investors that have managed their own properties may also be used to better than the 6%-7% annual income that many DSTs offer.

There are also, however, some advantages over the TIC structures that are otherwise used for 1031 exchanges.

Benefits of DSTs vs. TICs

No Direct Bank Involvement.

Banks are not involved directly with the investors, so that exit strategies may be enhanced.

Additional Option.

DSTs may provide an additional option that wouldn’t otherwise be available during the 45-day identification period.

No 35-Investor Limit.

The limitation to 35 investors applicable to TIC structures also doesn’t apply to DST investments.

A 1031 exchange can be an important tool for tax deferral, and DSTs can be another tool in the arsenal of investors who want to take advantage of such exchanges. It’s important, though, to be armed with some background knowledge and the help of skilled professionals.