It's Always Sunny in Delaware: 1031 Exchanges and the Benefits of DSTs
March 23, 2023
Our firm routinely advises investors and sponsors regarding the ins and outs of 1031 exchanges. We also specialize in representing issuers in securities offerings involving Delaware statutory trusts (“DSTs”). The unique intersection of these practices often sparks questions from issuers and investors alike about the benefits of DSTs. This short article seeks to briefly describe their benefits and identify significant market opportunities given the rapid changes in capital markets over the past few months.
Background
Owners of real property which is held for investment are often curious about Internal Revenue Code Section 1031. While there are many nuances of section 1031, such as the need for a qualified intermediary and strict deadlines to identify and acquire replacement property, the ability to sell property and reinvest the proceeds while deferring the need to pay taxes on capital gains is an attractive proposition to most investors. In fact, 1031 exchanges are often an integral part of estate planning. Heirs that inherit real property receive a stepped-up basis equal to the fair market value of the property on the date that the previous owner passed. Investors often utilize a 1031 exchange (or series thereof) to diversify and protect their assets as they age while providing heirs with the maximum benefit of their estate. One useful tool for investors to consider during this process is the DST.
A DST is an entity created under Delaware law, specifically the Delaware Statutory Trust Act. Unlike common law trusts, a DST is a separate entity which can own and dispose of property and sue or be sued. Depending on the exact circumstances, DSTs may be treated as “grantor trusts” for tax purposes, which allows investors to purchase beneficial interests in qualifying DSTs as “replacement property” in a 1031 exchange. In a typical qualifying DST structure, real property is owned by the DST, the DST is managed by a “signatory trustee” (sometimes referred to as a trust manager), and the property is often leased to a “master tenant” entity which in turn subleases the property to underlying tenants. The entity (or group thereof) that locates and puts the underlying real estate under contract, serves as the signatory trustee, and often serves a property management role is usually referred to as a “sponsor.”
In order to qualify as replacement property in a 1031 exchange, DSTs face a number of restrictions outlined in Revenue Ruling 2004-86. Among other limitations, the signatory trustee’s day-to-day activities are limited to collection and distribution of DST income, and the DST is prohibited from making significant modifications to the property, accepting additional capital, refinancing its debt, or otherwise varying its investment.
Benefits of DSTs
Despite the restrictions described above, DSTs are often used as a vehicle for real estate syndication for a number of reasons. First and foremost, qualifying DST interests may be purchased by an investor as replacement property in the investor’s 1031 exchange. Additionally, DSTs allow an investor completing a 1031 exchange to purchase fractional interests in larger, more sophisticated, or more diversified replacement property than would be possible if the investor were the sole owner of the replacement property. There are only two ways for an individual to purchase an interest in jointly held property as a part of the individual’s 1031 exchange: (i) as part of a qualifying tenancy in common (“TIC”) (see Rev. Proc. 2002-22), and (ii) as part of a qualifying Delaware statutory trust (see Rev. Rul. 2004-86). Following the collapse of the real estate market in 2008, lenders and other stakeholders quickly began to favor the DST over TIC structures largely because of the DST’s centralized control. Relatedly, many investors prefer the ‘hands off’ nature of DST investments. The centralized control associated with DSTs benefits both sponsors who wish to build a portfolio of assets under management while syndicating equity and investors who wish to take a step back from the hassles of management.
Current Market for DST Interests
Beneficial interests in DSTs are typically sold to investors through private placements under Rules 506(b) or 506(c) of Regulation D and are typically either: (i) sold directly by sponsors to investors, or (ii) by registered broker-dealers engaged by the sponsor. Last year was a record year for sales of beneficial interests in DSTs. Particularly in the beginning of 2022, sponsors could find and acquire new properties with favorable financing terms relatively easily, and there were plenty of investors seeking 1031 replacement property due to the high volume of real estate sales at the time. On the other hand, this year has presented new challenges, but not without creating opportunities. Investors seeking 1031 replacement property can afford to be more selective in 2023, as there is a greater volume and variety of DSTs on the market. Additionally, uniquely positioned sponsors with the ability to internally or cheaply bridge the sale of DST equity have a significant competitive advantage and the opportunity to build goodwill and strong relationships during what otherwise may be a turbulent time for other sponsors.