Delaware Statutory Trusts – The Versatile Like-Kind Exchange Tool

Anyone doing a like-kind exchange under IRC Section 1031, or anyone familiar with the 1031 exchange cottage industry, might also be aware of the sub-cottage industry of providing replacement property alternatives to taxpayers doing exchanges.  One of the most popular products offered by these helpful providers is an interest in a Delaware Statutory Trust (DST).  Owning a DST interest has the look and feel, in many ways, of owning an interest in an entity, such as a partnership or LLC.  But for tax purposes, owning a DST interest is treated as a direct ownership interest in the real property, and therefore passes muster as replacement property for a 1031 exchange.

So how do these DSTs work, anyway?  Why are they so effective as 1031 replacement property, and can they be used for purposes other than 1031 replacement properties?

Background

Section 1031 of the Internal Revenue Code provides that no gain or loss is recognized on the exchange of real property held for productive use in a trade or business or for investment (relinquished property) if the real property is exchanged solely for like-kind real property (replacement property).  “Like-kind” is broadly defined in the Treasury Regulations such that, in general, any real property held for use in a business or for investment is “like-kind” to any other real property.

Starting in the 1990s, promoters began offering customized replacement properties in the form of undivided interests in larger commercial properties to be held as tenants-in-common.  Interests in entities, such as partnerships or LLCs, have always been disqualified as potential 1031 replacement properties.  The challenge with tenant-in-common (TIC) interests was to consolidate and manage a group of TIC owners without the arrangement being deemed a partnership for tax purposes.

In 2002, the IRS made owning TIC interests easier with the publication of Revenue Procedure 2002-22.   Although Rev Proc 2002-22 didn’t provide a safe harbor for a TIC to avoid being deemed a partnership, it did provide standards for seeking an IRS ruling to that effect.  By doing so, it gave guidelines as to the IRS’s position regarding various details of the TIC structure which would (or wouldn’t) enable the TIC interests to be treated as undivided interests in real property, and not as interests in a partnership.

Still, there were difficulties with the TIC structure. Lenders did not favor it, and the requirement of unanimity for certain actions meant that individual TIC owners could hold the entire structure hostage. Also, TIC owners had no liability protection, such as a corporation or LLC would provide, since they were direct owners of the real property.

Enter the Delaware Statutory Trust.  DSTs provide their owners with the same liability protection as Delaware corporations.  Lenders were more comfortable with DSTs since a DST is a separate entity and not a collection of owners of undivided interests in the property.  In 2004, the IRS published Revenue Ruling 2004-86 in which the IRS gave specific guidelines which, if followed, assured that a DST interest would be treated, for tax purposes, as a direct ownership of the real property, which qualified DST interests as viable replacement properties in 1031 exchanges.

The hypothetical scenario used in Rev Rul 2004-86 is fairly simple:  Taxpayer A borrows money, buys real property (Blackacre), net leases Blackacre to Z, then forms a DST and contributes Blackacre to the DST, which assumes the debt on the property.  Initially A is the grantor and sole beneficiary of the Trust.  A then sells beneficial interests in the DST to B and C, who purchase the beneficial interests as replacement property in their 1031 exchanges.

The DST has a trustee, about whom we’re told nothing in the Rev Rul, but, importantly, the trustee has no power to vary the investment, which is essential for the DST to be treated as a trust and not as a business entity.  In order to assure that the trustee has no power to vary the investment, the Trust Agreement must provide that the trustee cannot have the power to do any of the following acts (the so-called “seven deadly sins”):

1. Dispose of the trust’s property and acquire new property (although the trustee can sell the trust’s property and dissolve the trust);
2. Enter into a new lease;
3. Renegotiate a lease with an existing tenant;
4. Take out a new loan on the trust’s assets;
5. Renegotiate an existing loan;
6. Invest cash received from the trust’s property in anything other than short-term investments guaranteed by the U.S. government; and
7. Make more than minor, non-structural modifications not required by law.

In the real world, the simple structure described in Rev Rul 2004-86 usually involves a sponsor, who acquires real property and net leases it either to a single commercial tenant, or, for example in the case of multifamily housing, to a master tenant who will manage the property and enter into subleases with the tenants.  The Sponsor will then form a DST and contribute the property to the DST, and sell beneficial interests in the DST to investors.  The DST generally has two trustees: a Delaware statutory trustee, and a “signatory trustee,” usually the sponsor or an affiliate, which actually manages the affairs of the DST.

An investor buying a DST interest is usually committed to owning the DST interest for the life of the DST, which generally ends when the property is sold and the DST is liquidated.  If there is debt encumbering the property, the DST ends when the term of the loan ends since the trustee is prevented from entering into a new loan, so the property is sold when the loan terms out.

Other Uses For DST Interests

As noted at the outset, providers specialize in offering DST interests as replacement property for 1031 exchangers.  DST interests come in a variety of shapes and sizes, and the needs of most exchangers can usually be accommodated.  For example, an exchanger can replace the debt that was paid off in connection with the sale of relinquished property by finding a DST with a similar proportionate amount of debt encumbering the DST’s property.

Aside from simply providing readily available replacement properties for exchangers, DSTs can be useful when partnerships or LLCs seek to distribute property to their partners or members who want to do their own exchanges, i.e., a so-called “drop & swap.”  If the partnership or LLC has already entered into the sale agreement, it may be too late to simply drop the property out to the partners without adverse tax consequences. If there are a limited number of partners, one solution may be to flip the actions around into a “swap & drop.”

In a swap & drop using DST interests, the partnership or LLC that has entered into the sale agreement will go ahead and complete the 1031 exchange, and will purchase as its replacement property DST interests chosen by the partners.  The partnership will hold those DST interests until the exchange is old and cold, and then distribute the DST interests to the partners in liquidation of their partnership interests. Since DST interests can be freely divided up, individual partners can either receive the DST interest they selected, or each partner can receive a proportionate amount of each of the DST interests, or any combination thereof.

Another use for DST interests in the drop & swap context is the so-called “synthetic drop & swap.”  The synthetic drop & swap involves the conversion of a partnership or LLC into a DST using state law conversion statutes. Following such conversion, the partnership interests of the former partners become beneficial interests in the DST.  When the DST sells the real property, each owner of a DST interest will be treated, for tax purposes, as owning an undivided interest in the real property, which qualifies as relinquished property for a 1031 exchange.  The DST is treated as the same entity as the partnership that entered into the sale agreement.  This “synthetic drop and swap” has the following advantages over a conventional drop & swap and TIC arrangement:

• Liability Protection. A TIC arrangement does not provide liability protection to the TIC owners; a DST provides the same liability protection for owners of DST interests that a Delaware corporation provides for its shareholders.
• Title; Lenders’ Liens: When property is dropped to TIC owners, title to the property changes, and a lender’s lien on the property does not automatically transfer. When a partnership converts to a DST, all property automatically transfers by operation of law, so title to the real property, and the rights of creditors and liens on property, remain unimpaired.
• Sale Contract: When property is dropped to TIC owners, the partnership needs to assign the sale contract to the TIC owners.  With a conversion to a DST no assignment is necessary since all contract rights and obligations automatically transfer by operation of law.
• Management Structure. In a TIC structure, the TIC owners negotiate and consummate the sale of the real property, and certain actions requiring unanimous agreement can be held up by a single TIC owner. In a DST, the trustee can have powers more akin to those of a general partner or LLC manager, with less required participation by the DST owners.

Bottom Line

Delaware Statutory Trusts are useful in the 1031 exchange context for providing readily available replacement properties for exchangers, and can be used more creatively to facilitate “swap & drops” and “synthetic drop & swaps.”  We can advise clients doing exchanges on providers of DST interests, and on the possible use of DSTs to help facilitate their transactions.