DSTs are the future of 1031 real
estate investing.
by Steven R. Meier
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.
Section 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.
DST
Advantages
Prior to 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.
Management and control. 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.
In 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.
Structural simplicity. 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.
By 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.
Enhanced scalability and
diversification. Because 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.
DST
Challenges
In 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.
These 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 with
appropriately.
Given 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.
With 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.
