Delaware Statutory Trust (DST) Basics

What Is a Delaware Statutory Trust?

A DST is a separate legal entity created as a trust under Delaware statutory law. Delaware law permits a very flexible approach to the design and operation of the entity. However, to use a DST in a Section 1031 tax-deferred exchange private placement program, it is necessary to comply with the requirements of IRS Revenue Ruling 2004-86 so that a beneficial interest in the trust is treated as a direct interest in real estate for income tax purposes (One should note that unlike an IRS Revenue Procedure, an IRS Revenue Ruling may be relied upon by other taxpayers in defense of a 1031 exchange position). It is also necessary to meet lender requirements, especially if the loan is to be securitized on a secondary market to achieve favorable financing. Therefore, a DST must be:

• A special purpose entity;

• Bankruptcy-remote; and

• A very passive holder of real estate (the trustees will have minimum powers and the beneficiaries will have no powers with respect to the mortgaged property).

Thus, the use of a DST will generally be limited to long-term “A” credit triple-net leased properties (a “box-in-one”) or properties leased to an affiliate of the sponsor whom will operate the property on a triple net basis (a “master lease”).

Benefits

As discussed below, a DST structure to owning fractional real estate has the following benefits:

1. DST investor's enjoy limited liability to their personal assets due to the bankruptcy remote provision of the DST.

2. The minimum investment amounts are significantly lower for a DST offering (typically $100,000).

3. No need for DST investors to have to sign non-recourse loan “carve outs".

4. DST investors typically have no closing costs.

5. DST investors do not have to maintain an LLC.

6. IRS Revenue Ruling may be relied upon in defense of a 1031 exchange position.

The DST will own 100 percent of the fee interest in the real estate. Unlike a tenancy-in-common program, the lender only needs to make one loan to one borrower. The DST is bankruptcy remote, that is, it contains SPE provisions, which prevent the bankruptcy creditors of the beneficiaries from reaching the DST’s property and gives the lender greater comfort that it can foreclose on its first mortgage of the real estate should the need arise.  Likewise, DST investor's enjoy limited liability to their personal assets due to the bankruptcy remote provision of the DST.

Furthermore, unlike a TIC offering that is limited to 35 investors per Revenue Procedure 2002-22, a DST offering may have up to 499 investors before it would be considered a public offering and be required to be registered with the SEC.  Thus, the minimum investment amounts are significantly lower for a DST offering.  Most DST sponsors will set arbitrary minimum investment levels (typically $100,000) to limit the number of investors to a manageable number. 

The beneficiaries’ only right with respect to the trust is to receive distributions. They have no vote or say in operations of the property. Since they cannot be “bad boys,” there should be no need for DST investors to have to sign on any non-recourse loan “carve outs.” The lender should need to look only to the DST sponsors with respect to the carve outs.

The lender does not need to underwrite or qualify any of the investors because they are totally isolated from the operation of the property. Other than Patriot Act considerations, due diligence investigations of the investors should not be necessary. Further, the better sponsors only sell to accredited investors. All of this eliminates the need for the lender to monitor transfers of beneficial interests.

Consequently, DST investors typically have no closing costs associated with the creation of a single member LLC as in TIC offering (saving as much as $5000 per investment) and DST investors do not have to maintain an LLC by paying annual state filing fees for that may dilute cash flows. 

The signatory trustee of the DST will generally be the sponsor of the private placement offering or one of its affiliates. Unlike a TIC deal, there is no one-year time limit on the trusteeship or the term of the property manager. This will give the lender comfort that the sponsor will have a continuing presence in operating the property. The trust agreement contains provisions requiring the trustee to comply with all of the terms of the loan documents and states that they are for the benefit of the lender.

A DST also has a Delaware trustee (required by statute), so there is no worry that the trust will inadvertently terminate. The trust will contain a provision that prevents the trustee from distributing the property as TIC interests to the beneficiaries.

Master Tenant

As discussed below, the tax law requires that the trustee be prohibited from taking certain actions with respect to leasing, financing and capital-raising with respect to the property, and the beneficiaries have no control over the operations of the mortgaged property; therefore, a master lease is required unless there is a single-property long-term triple-net lease to a credit tenant. The master tenant (generally an affiliate of and controlled by the sponsor) will enter into leases of the mortgaged property to residential or commercial “subtenants,” handle maintenance and repairs, contract with the management agent (also often an affiliate of the sponsor) and, generally, be empowered to do everything that an owner of the mortgaged property would be empowered to do. This also eliminates the concern raised in TIC transactions as to how to ensure the unanimous consent of the TICs to certain necessary management actions. Loan documents can easily be adapted for this format.

For example, a subordination, assignment and security agreement would effect an assignment of leases and rents from the master tenant in favor of the lender, would provide that a default under the master lease would constitute an event of default under the security instrument, require the timely provision of books and records and other financial reports and would directly impose on the master tenant certain obligations and restrictions with respect to the operation of the mortgaged property. The loan agreement would restrict transfers by the master tenant of the lease and of controlling interests in the master tenant.

The master tenant would also be structured as an SPE, adding yet another layer of bankruptcy protection for the lender. Because most master tenants would only be minimally capitalized, the sponsors will be the parties that own and control the master tenant and have the requisite net worth and liquidity to satisfy lender requirements. The master lease will generally provide for rent to be paid by the master tenant to the DST in a set amount equal to debt service plus a market rate of return. The master lease structure economically incentivizes the master tenant to maximize the mortgaged property’s net operating income because the master tenant retains all net operating income over and above debt service and rent payments under the master lease, and incentivizes the master tenant to cover short-term operating deficits to protect its desired return and its valuable investor reputation in the industry.

Additionally, the better sponsors self-reserve from net operating income (over and above typical lender replacement reserves) for unanticipated repairs and uninsured losses because there is no real ability to negotiate changes in the master lease terms and rent payments with the DST trustee.

IRS Requirement Causing Lender Concerns

IRS Revenue Ruling 2004-86, which forms the basis for a DST transaction in a Section 1031 exchange program, has prohibitions on the powers of the trustee, in order for a beneficiary to be treated as acquiring a direct interest in real estate for tax purposes. These restrictions are built into the trust agreement and have become known as the “seven deadly sins.” They are:

1. Once the offering is closed, there can be no future contributions to the DST by either current or new beneficiaries.

2. The trustee cannot renegotiate the terms of the existing loans and cannot borrow any new funds from any party unless a loan default exists as a result of a tenant bankruptcy or insolvency.

3. The trustee cannot reinvest the proceeds from the sale of its real estate.

4. The trustee is limited to making capital expenditures with respect to the property for normal repair and maintenance, minor nonstructural capital improvements, and those required by law.

5. Any reserves or cash held between distribution dates can only be invested in short-term debt obligations.

6. All cash, other than necessary reserves, must be distributed on a current basis,

7. The trustee cannot enter into new leases or renegotiate the current leases, unless there is a need due to a tenant bankruptcy or insolvency.

Because of these IRS restrictions, the only forms of real estate ownership transactions that will work in a DST are a master lease transaction whereby the master tenant takes on all of the operating responsibilities or a triple net long-term lease to an “A” credit tenant. The sponsor will also attempt to mitigate against the effect of these seven prohibitions by:

• Acquiring only new or recently rehabilitated Class A properties;

• Raising substantial funds for capital reserves in the offering;

• Having financing terms which go out seven to 10 years, but less than the term of the master lease, and;

• Planning for the sale of the mortgaged property prior to the maturity date of the loan.

The solution to give the lender comfort against the DST’s inability to act if the loan is endangered is to place an operative provision in the trust agreement providing that if the trustee determines that the DST is in danger of losing the mortgaged property due to an actual or imminent default on the loan and tax-related restrictions are preventing the trustee’s ability to act, (the seven deadly sins), the DST can convert into a limited liability company (the “springing LLC”) with a lender pre-approved operating agreement. Delaware law permits the conversion by what is basically a simple election which does not constitute a transfer under Delaware law. The “springing LLC” will contain the same SPE and bankruptcy remoteness provisions as the

DST (for the lender’s benefit), but it will permit the raising of additional funds, the raising of new financing or renegotiation of the terms of the existing financing and the entering into new leases. In addition, it will provide that the trustee (or sponsor) will become the manager of the LLC with full operating control.

Conclusion

A DST borrower with a master tenant owned and controlled by a quality sponsor should be an attractive borrower for a lender. Various financing sources have embraced the DST structure. A steady market should develop for DSTs because they are much less complex than the structure of a typical TIC transaction, they shield investors from liabilities with respect to the mortgaged property and they remove the investors from involvement in operation of the property.

For more information on this matter or if we may be of further assistance please contact us for a free consultation by e-mail at info@cornerstoneexchange.com or call us at (800) 781-1031 or (714) 939-1031.

Security investments offered through Allied Beacon Partners (Member FINRA, SIPC)

Cornerstone Real Estate Investment Securities is not affiliated with Allied Beacon Partners, Inc.