January 30, 2015
A. IRS Guidance
- Revenue Ruling 2004-86 (July 20, 2004) held that (a) the Delaware statutory trust (“DST”) described therein qualifies as an investment trust under IRC §301.7701-4(c) that will be classified as a trust for federal tax purposes, and (b) that a taxpayer may exchange real property for an interest in the trust without recognition of gain or loss under §1031 if the other requirements of §1031 are satisfied.
- For a trust to be classified as an investment trust, the trustee must not have the power to vary the investment of the settlor (or any subsequent beneficiaries). The powers of the trustee of the DST in Revenue Ruling 2004-86 were very limited, and the Ruling provided guidance that the DST would not qualify as an investment trust if the trustee had the power to do one or more of the following:
- dispose of the property owned by the DST and acquire new property
- renegotiate the lease of the property with the lessee or enter into leases with tenants other than the lessee (except in the case of the bankruptcy of the lessee)
- renegotiate or refinance the obligation used to purchase the property
- invest cash received to profit from market fluctuations
- make more than minor non-structural modifications to the property not required by law.
- Persons acquiring undivided fractional interests in the DST from the original grantor of the DST are treated as grantors of the DST under IRC §1.671-2(e)(3) and are considered to own the assets of the DST attributable to that interest for tax purposes; accordingly, each of such persons are considered for federal income tax purposes to own an undivided fractional interest in the real property owned by the DST.
B. Types of Transactions Currently Being Done
- Shopping center and other commercial real estate transactions with existing rental income purchased by DST as “replacement property” for subsequent 1031 transactions.
- DST typically formed by single settlor who is issued all of the units in the DST; settlor sells those units to third parties (generally, those persons seeking “replacement property”) in 1031 transactions.
- Typical transaction structure
- Loan to DST for acquisition of property payable over short term (e.g., 10 years), with a balloon payment at maturity.
- Property subject to a triple net Master Lease with a term equal to the loan term (lessee under Master Lease subleases property to tenants).
- DST term identical to loan and lease terms (with possible reconstitution provision following dissolution at end of term).
- Property sold prior to end of DST term and proceeds used to pay off Lender.
- Trustee entitled to rely upon advice of real estate consultant regarding maintenance and sale of property.
- Rental income collected by trustee and invested in U.S. Government obligations and distributed quarterly to beneficiaries.
C. Benefits of Revenue Ruling/DST Structure
- The alternative structure is the Tennant In Common (“TIC”) structure, which is limited (by most lenders) to 2 or 3 participants; the number of DST beneficiaries is limited, as a practical matter, by securities laws (the units are typically offered by means of a private placement memorandum), however, a maximum of 30 beneficiaries is typical. As a result, the “replacement property” acquired by the DST may be 10 to 15 times greater in value than in a TIC transaction.
- Title is held in name of DST; no need to incur cost or trouble associated with transferring title to purchasers of units (and transfer taxes may be avoided, depending upon the relevant state law).
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