DSTs are the future of 1031 real estate investing.
As the markets continue their recovery in 2013 and beyond,
investors face a more challenging tax environment. Federal capital gains taxes
have increased from 15 percent to 20 percent for high-income taxpayers, passive
investment income is now subject to a 3.8 percent Medicare tax, and many states
are attacking budget shortfalls through higher taxes. Separately, scores of old
Section 1031 investment programs — designed to defer taxes pursuant to Section
1031 of the federal tax law — are coming full cycle in the next three to five
years. This correlation of events is reinvigorating interest in new tax-deferred investment programs.
1031 programs were popular in the mid-2000s, principally for high-net-worth
individuals and family trusts and offices, commanding several billion dollars
in invested capital. They declined dramatically between 2008 and 2011, dipping
to around $100 million in invested capital in 2009. However, Section 1031
programs are beginning to rebound again, growing to roughly $250 million of
invested capital in 2012, with potential growth of $1 billion to $3 billion of
invested capital per year over the next three years.
2008, the predominant investment vehicle for Section 1031 programs was the
tenancy-in-common, or TIC, program. Now virtually all new Section 1031 programs
are being structured as Delaware Statutory Trust, or DST, programs, principally
for the following reasons.
.In TIC deals, the Internal
Revenue Service requires that certain fundamental decisions, such as selling or
refinancing the property or entering into lease, management, or brokerage
agreements, be made unanimously by investors. During the market collapse of
2008–11, numerous TIC deals were derailed because one or more rogue investors
could hold up a deal.
contrast, a DST structure takes all decision-making out of the hands of
investors and places it with a sponsor-affiliated trustee. Accordingly, in
times of crisis, DSTs are more agile decision-makers than TIC programs.
TIC deals require each investor to
form a special purpose entity, usually an LLC, to own the TIC interest and to
join a co-ownership agreement (governing relations with other investors), a
management agreement or master lease (governing relations with the investment
program sponsor), a loan agreement, and a real estate deed. In addition, each
investor must execute an environmental indemnity and a “bad boy carve-out” loan
guaranty, which provides for personal recourse against the investor if he or
she takes certain actions that are in bad faith or that cause a loan default.
This plethora of arrangements is difficult to digest, costly to maintain, and
involves a high level of investor risk.
contrast, a DST investor executes only one document — a trust
agreement.There are no deeds or loan documents for investors to sign and
no environmental or carve-out guaranties for them to execute.
scalability and diversification.
the IRS limits the number of investors in a single TIC program to 35, they are
generally limited to properties less than $25 million in total value and
require large minimum investments, often at least $500,000. DSTs, however, are
not subject to an investor limit under the tax law, and under the 2012 JOBS
Act, can have up to 2,000 investors.Thus, DSTs can own properties with
aggregate value much greater than any TIC deal, while simultaneously
accommodating much smaller minimum investments, allowing diversification of
investments across multiple DST programs.
certain respects, DST programs are more restrictive than TIC programs. For a
DST to qualify for Section 1031 purposes, it must not violate the IRS’ “seven
deadly sins.” That means that a DST: (1) cannot receive new capital after an
offering is closed; (2) cannot renegotiate or enter into new mortgage debt
unless there is a tenant bankruptcy or insolvency; (3)cannot
renegotiate any of its property leases or enter into any new leases unless
there is a tenant bankruptcy or insolvency; (4) cannot reinvest the proceeds
from the sale of its property; (5)cannot
redevelop property and, in fact, is limited to performing only normal
maintenance and minor nonstructural improvements unless it is required to do
more by law; (6)must
hold its reserves in short-term debt obligations; and (7) must distribute all
cash, other than normal reserves, on a current basis.
restrictions caused many investors and broker-dealers to prefer the TIC
structure during the mid-2000s. Ironically, many property problems arise from
tenant bankruptcies or insolvencies, which a DST can resolve quickly, but a TIC
structure can only resolve through a long and uncertain decision process. When
issues arise that a DST cannot address due to the seven deadly sins, it
converts into an LLC.While this conversion inhibits investors’ ability to
do future Section 1031 transactions, it allows property emergencies to be dealt
the restrictions on their activities, DSTs are not designed for all property
classes. They are best suited for properties subject to a long-term lease to a
creditworthy tenant on a triple-net basis. They can also successfully be used
with a master-lease structure to hold multifamily, student and senior housing,
hospitality, and self-storage facilities.
markets in full recovery, tax rates on investment income nearly 50 percent
higher than they were in the 2000s, and scores of old Section 1031 investment
programs coming full cycle, many real estate investors will turn to DST
programs to shelter their real estate investment gains.
R. Meier is partner at Seyfarth Shaw LLP in Chicago.
Contact him at email@example.com.