Understanding DSTs, TICs and U.S. Code § 1031
While discussing the newly formed United States of America in a 1789 letter, Benjamin Franklin stated, “Our new Constitution is now established, and has an appearance that promises permanency; but in this world nothing can be said to be certain, except death and taxes.”
While the Grim Reaper still has a perfect track record, Ben was speaking about nine scores (or 180 years) too early to know about U.S. Internal Revenue Service Code § 1031’s implications with respect to commercial real estate “1031 like-kind” exchanges, or 1031 exchanges, and the tax benefits that these can have for commercial real estate investors
Temporary Deferral Can Sometimes Become Much More
In 1031 exchanges, the seller of an asset, who would otherwise be obligated to pay a capital gains tax upon the asset’s profitable disposition, is instead able to move those funds into a new like-kind property without paying capital gains taxes on the asset’s appreciation.
1031 exchanges are considered a tax-deferment since, theoretically, a seller who executes the 1031 exchange will have to pay taxes upon the disposition of the new asset. However, in practice the capital gains tax can often be permanently avoided in a couple of different manners:
If the gain is continually rolled into new 1031 exchanges until the time of the seller’s death, the assets will fall to the heirs of the deceased and have their tax basis reset in a non-taxable event.
If the gain is rolled into an asset which then becomes the seller’s primary residence, the seller may permanently avoid up to $500,000 in capital gains taxes upon the future disposition of the seller’s primary residence.
The Rise and Fall of Tenancy in Common
In early 2002, Tenancy-in-Common (TIC) ownership structures were approved by the U.S. Treasury Department as acceptable like-kind investment vehicles for 1031 exchanges. In brief, TIC is a structure that allows up to 35 investors to hold a property together, each owning a fractional ownership stake.
Regardless of investment size, all investors in a TIC have equivalent voting rights. Any major decision, which may include items such as leasing or capital investment at the property, requires the unanimous approval of all members of the TIC.
While pooling money together in this manner allowed 1031 exchange sellers to invest in much larger assets than they would have been able to do so by themselves, the unanimous approval control structure of TICs was fairly disastrous during the Great Recession. Many 1031 TIC exchanges went into foreclosure because TIC members were unable to reach the unanimous decisions they needed to properly manage properties after tenants disappeared and commercial real estate values plummeted.
In the wake of TIC troubles through the Great Recession, many banks refused to lend on assets held by TIC structures. In response to the lack of financing, as well as the large number of foreclosures experienced by TICs, the Delaware Statutory Trust (DST) was approved as a 1031 exchange like-kind vehicle in 2004 by the IRS. The DST has since become the primary investment method for pooled 1031 exchange investments.
Making Room for the Delaware Statutory Trust (DST)
Unlike TICs, which require unanimous approval of all investors for all major decisions, DSTs have an appointed trustee who resides over the investment. Investors in the DST have no direct control or decision-making authority with respect to the investment. The trustee who oversees the asset has limited power to exercise over the investment.
The Seven Deadly Sins for a DST
The governing laws for what a trustee of a DST can and cannot do in the management of a property are known as The Seven Deadly Sins for a DST:
After the offering is closed, the trustee may accept no future equity contributions from either new or existing investors in the DST.
The trustee may not procure any additional debt financing for the investment, nor renegotiate the terms of any existing loans.
The trustee may not reinvest the proceeds from the sale of the investment. The proceeds must flow back to the investors in the DST.
The trustee may only make capital expenditure at the property if it serves one of the following purposes: (i) normal repairs and maintenance of the property, (ii) minor, non-structural capital improvements, or (iii) capital expenditure required by law. The trustee may not implement any significant capital expenditure plan at the property.
Any liquid cash held by the DST between distribution dates may only be invested in short-term debt obligations.
All liquid cash, save for necessary reserves, must be distributed to investors in the DST on a regular basis.
The trustee cannot enter into new leases or renegotiate leases (unless approved under a master leasing agreement at the inception of the DST), although the trustee can usually execute a new lease for a given space should the existing tenant for such space default on its lease at the property.
Properties that are suitable for DST structures
Given the limited controls exercisable with DSTs, certain types of assets tend to lend themselves better to DST structured investments. Assets which require minimal leasing and management, such as single-tenant, triple-net leased properties with no near-term lease expirations, are easiest to manage within a DST structure.
Due to the limited assets that make sense for DST investments and the significant amount of 1031 money in the commercial real estate market, properties that have characteristics that make them prime 1031 exchange candidates often sell at a premium to other assets in the market, which probably would not work in DST structures.
Important considerations for DSTs
Taking precautions with what assets are purchased in DSTs and choosing a competent trustee are of paramount importance in DST investments. However, even when precautions are taken, every commercial real estate investment has inherent risks and should a DST investment require more active management than is possible within a DST, most DSTs have what is known as a “springing LLC” provision.
Should the trustee feel as if the DST is at risk of losing the property because of its inability to execute active management over the investment, the trustee may convert the DST into an LLC with control provisions which were agreed upon at the inception of the DST. Upon the conversion of the DST to an LLC, investors in the DST will be forced to realize the taxable gain which the DST was intended to defer.
However, the trustee of the DST, who still manages the investment, may now engage in active management such as raising additional capital as necessary and executing new leases to avoid default. The “springing LLC” provision cannot be incorporated into TICs, since there is no trustee to initiate the LLC conversion.
RealtyMogul+ DST = A 1031 Exchange Opportunity
RealtyMogul has a 1031 exchange-eligible investment platform that offers real estate investments structured as DSTs. By working with DST sponsors that have significant track records and targeting 1031 exchange opportunities we believe make sense for DST structures from a management perspective, we look forward to offering our investors a robust pipeline of 1031 exchange opportunities.
Are you currently coming into a 45-day identification window for a 1031 exchange? Are you expecting to anytime soon? Do you have surplus proceeds from an existing exchange that you need allocated quickly? Or, are you interested in adding 1031 properties to your portfolio? If so, reach out to RealtyMogul investor representative today to discuss current and anticipated 1031 exchange opportunities available through the platform.
If you have a property you are interested in exchanging, you can fill out this form to get started.
As with all investing, investors should understand the risks associated and nothing is guaranteed.