In order to postpone and possibly prevent paying capital gains tax on the sale of other investment real estate holdings, investors frequently turn to DSTs, or Delaware Statutory Trusts. A DST enables investors to use a 1031 exchange into a DST that is actively managed by a qualified third-party, as opposed to a standard 1031 exchange from one wholly-owned property to another. As opposed to owning real estate that needs their active management, this enables the investor to play a more passive, supporting role.
In a diverse portfolio of institutional-grade real estate, investing in a DST may offer investors a fantastic, hassle-free option to generate monthly passive income.
However, DST investments follow the same stringent guidelines as conventional 1031 swaps. The IRS (ruling 2004-86) proposed the "seven deadly sins" of DSTs in order to explain the laws and standards governing DSTs. These regulations set strict parameters on how DSTs must function and restrict the trustees' authority.
Each of the seven deadly sins of DSTs is described in detail in this article.
- After a DST offering closes, neither current nor new investors are allowed to contribute funds to the DST in the future.
In contrast to other real estate syndications or funds, a DST offering that has closed may not issue capital calls or ask for additional contributions from investors. For this reason, investing in a DST entitles you to a pro rata portion of property ownership based on the amount of your initial investment. Any further investments might alter ownership proportions, which consequently might reduce someone's ownership part. There are no more contributions accepted after the DST offering closes since doing so might affect investors' claims to the DST assets.
- The Trustee of a DST is not permitted to take out additional loans or modify the conditions of current loans.
The sponsor of a DST is obligated by law to declare the loan amounts connected with the assets held in that DST prior to accepting investments. This enables potential investors to assess a portfolio's debt-to-income ratio as part of their due diligence process since the kind, interest rate, and terms of debt can affect investment returns. This choice precludes the sponsor from taking on additional debt or refinancing into a new mortgage that may otherwise affect the beneficiaries' interest because DST investors have very little control over investing decisions.
However, there is an exception to this rule. In the event of a tenant's bankruptcy or insolvency, the DST sponsor may be allowed to renegotiate loan conditions or take on extra debt, but only after extensive paperwork and scrutiny.
- A DST is unable to reinvest the money it receives from selling its real estate.
The IRS forbids a sponsor from reinvesting the earnings from the sale of the DST into new investment property, unlike real estate investment trusts, or REITs. Instead, the numerous DST beneficiaries must get a portion of the sale revenues. The DST's investors can then take their portion of the sales profits and either cash out completely or roll the winnings into another DST (via a new offering with the same sponsor or a different sponsor altogether). The capital gains of those who choose the latter will be liable to both state and federal taxes at that time.
- The DST sponsor's ability to make capital upgrades is restricted, with the exception of those related to (a) routine repair and maintenance; (b) small, non-structural capital improvements; and (c) those mandated by law.
Any DST sponsor's ability to make enhancements is subject to IRS restrictions. The justification is that historically, certain sponsors have chosen to engage in enhancements that ultimately jeopardize the investment of the beneficiaries. This clause aims to safeguard investors from regrettable capital upgrades.
- The DST may only reinvest cash reserves retained between distribution dates in short-term debt obligations.
The majority of DSTs have sizeable cash reserves on hand since DST sponsors are unable to acquire further funds or incur new debt once the offering closes. If necessary, these cash reserves might be used to fund more investments. However, the IRS only permits DST sponsors to invest cash in short-term loan commitments that can be quickly liquidated prior to the DST's next distribution date in order to prevent the use of cash in a speculative manner (such, for example, the above-mentioned fruitless capital improvements) (and therefore, is considered a cash equivalent).
One benefit of this clause is that it enables the DST sponsor to quickly implement strategic capital enhancements that raise the DST's value without jeopardizing the beneficiaries' investment.
- Co-investors must receive monthly distributions of all funds, minus any necessary reserves.
Only "required" reserves can be kept on hand by a DST to pay for property management, urgent maintenance, repairs, and other unforeseen costs. If not, all cash earnings and sales proceeds from DST property must be distributed to investors on the dates agreed upon. This "deadly sin" aims to stop sponsor theft of funds and ensures that the DST beneficiaries consistently receive their rewards.
- After the offering has ended, the DST sponsor is not permitted to renegotiate current leases or sign new ones.
The IRS forbids the sponsor from signing new leases or revising existing leases once a DST has ended. This is due to the fact that lease terms may significantly affect income and, consequently, investors' returns.
Using a Master Lease structure is one way for DSTs to "get around" this clause, if you will. The DST rents real estate to a "master tenant" under a master lease, who is then free to sign new leases or renegotiate existing ones with sub-lessors. The master lease offers some predictability to DST investors while giving the master tenant some latitude to modify leases for the property's advantage. This guarantees that the sponsor won't make dangerous leasing choices and places the onus on the master tenant to uphold the terms of the master lease.
In the event that a tenant files for bankruptcy or becomes insolvent, the sponsor may engage into a new lease or renegotiate the terms of the existing lease for that tenant.
DSTs could appear to be too controlled at first glance. The seven deadly sins of DSTs were merely implemented to safeguard investors, in actuality. Both the sponsor and the investors must strictly abide with these regulations. As a result, before investing in a DST, investors will want to thoroughly investigate any sponsor. Look for sponsors in particular who have the confidence to discuss the seven deadly sins of DSTs. It will be a good indication of the sponsor's expertise and aptitude if they can explain the nuances of these regulations.
Call us right away if you need assistance with a 1031 exchange. Investing your capital gains into a DST is a procedure that our staff would be pleased to help you through. Investors will discover that doing so is a terrific strategy to postpone paying capital gains tax while also switching from active to passive, diversified real estate investing.
This is neither a buy-side nor a sell-side solicitation of securities. The material presented here is purely for informational purposes and shouldn't be used to guide financial decisions. Every investment has the chance of losing some or all of the money. Future outcomes cannot be predicted based on past performance. Prior to investing, consult a financial or tax expert.
1031 Risk Disclosure:
* There is no assurance that any strategy will be effective or achieve investment goals; * Property value loss is a possibility for all real estate investments over the course of ownership; * Tax status may change depending on the income stream and depreciation schedule for any investment property. All funded real estate investments have the risk of going into foreclosure; adverse tax rulings may prevent capital gains from being deferred and result in immediate tax liability;
1031 exchanges are illiquid assets since they are frequently issued through private placement offerings. There is no secondary market for these investments. * Reduction or Elimination of Monthly Cash Flow Distributions - Similar to any real estate investment, the possibility of suspension of cash flow distributions exists in the event that a property unexpectedly loses tenants or suffers significant damage; * The impact of fees and expenses - The costs of the transaction could have an influence on investors' returns and even surpass the tax advantages.