Introduction 

As an experienced Qualified Intermediary (QI), you recognize our knowledge of DSTs helps your clients recognize a vast market of replacement properties they otherwise might not have been familiar with. In our commitment to helping you grow your understanding of DSTs - and further distinguishing your practice - we offer this discussion that goes a few steps deeper. 

This blog will explore more of the intricacies of DSTs, covering securitized real estate, regulatory considerations, the role of the DST sponsor, and the full cycle of a DST.

Why Securitized Real Estate?

In some situations, investors may be ready to sell an investment property but may not be prepared to buy another property or properties on their own. Securitized real estate provided through a sponsor company gives investors the opportunity to own shares of real estate while still qualifying for a 1031 exchange. The most common form of securitized real estate that investors may encounter today is the Delaware Statutory Trust (DST).

IRS ruling 2004-86 distinguished the DST from limited partnership interests and created it as a 1031 exchange option. The DST is a limited-purpose entity, which can hold title to real property. Property can be co-owned through beneficial interests. Active management of real assets is delegated by DST lease contracts. Debt is allocated pro rata for exchange purposes, and the active management must be conducted outside of the trust.

The DST ownership structure offers the following advantages:

1. No Limits on Co-Owners: Investors have no say in property management decisions, relying entirely on the sponsor's expertise.
   

2. Easier Transfer of Interests: DSTs may make it easier to sell investment interests to third-party investors since lenders don’t have to approve the sale.
   

3. Simplified Financing: DSTs must adhere to specific regulations, known as the "seven deadly sins," which limit their operational flexibility. These include prohibitions on accepting additional capital, renegotiating leases, and making significant improvements.

4. Lower Transaction Costs: There are lower investor and sponsor transaction costs due to less investor paperwork.

   
   

Securities and Regulatory Considerations

When entering into a DST, investors are purchasing a complete financial package or arrangement. Investors rely on the expertise of the sponsor company to provide a good investment. For this reason, and because investors are investing money in common enterprises with the expectation of a profit, DSTs meet the definition of an investment contract or securities.

Securities are sold through broker-dealers who are registered and governed by the Financial Industry Regulatory Authority (FINRA), the Securities and Exchange Commission (SEC), and state securities commissions. Securities have disclosure requirements and a private placement memorandum, and the sponsor or seller is subject to the anti-fraud regulations of the Securities Act of 1933.

The Seven Deadly Sins

The IRS has established strict regulations, known as the "seven deadly sins," that DSTs must adhere to in order to qualify for 1031 exchange treatment. These restrictions ensure that the DST maintains its passive investment structure:

1)  No Future Capital Contributions:

     - The DST cannot accept additional capital from investors after the initial offering period.

2)  No Renegotiation of Debt:

     - The terms of any debt must remain fixed; the DST cannot renegotiate existing loans or acquire new financing.

3)  No New Leases:

     - The DST is prohibited from entering into new leases or renegotiating existing leases, maintaining a stable cash flow structure.

4)  No Significant Capital Expenditures:

     - Only minor, non-structural repairs are allowed; major improvements or renovations are prohibited.

5)  No Reinvesting Proceeds:

     - Cash from property operations or sales must be distributed to investors; it cannot be reinvested in other properties.

6)  No Sale of the Property:

     - The DST cannot sell its property and acquire a new one, ensuring that the trust’s operations remain passive.

7)  No Return of Capital to Investors While Invested:

     - Investors cannot receive their initial capital back during the investment period, maintaining the trust's structure and integrity.

Adhering to these restrictions is crucial for maintaining the tax-deferred status of the DST under a 1031 exchange.

The Role of the DST Sponsor

DSTs are offered through real estate sponsors. Sponsors are typically experienced real estate companies that research the market, locate investment properties, arrange for the property’s purchase, financing, and management, and then offer shares to multiple 1031 exchange co-owners. 

Sponsors process cash-flow disbursements to investors and provide regular investor reports. Ultimately, the sponsor coordinates the property sale and provides investors with their portions of the proceeds.

Though sponsors make DST opportunities possible, there are a few drawbacks. They are the decision-makers, so investors may have limited decision-making abilities. Sponsors may have conflicts of interest, and their choices may have negative impacts on the investment. There may be additional fees associated with using a sponsor.

Understanding the Full Cycle of a DST

The lifecycle of a Delaware Statutory Trust (DST) involves several key phases, each crucial for the success and compliance of a 1031 exchange. Here’s a breakdown of the full cycle:

1)  Formation and Sponsorship:

     - A sponsor, typically an experienced real estate company, identifies a property and establishes a DST to hold the title.

     - The sponsor arranges for the acquisition, financing, and management of the property, offering shares to multiple investors.

2)  Investment Period:

     - Investors purchase beneficial interests in the DST, which qualifies them for 1031 exchange benefits.

     - The DST generates passive income for investors through property operations, managed by the sponsor or a designated trustee.

3)  Operation and Management:

     - The sponsor handles all property management activities, including leasing, maintenance, and compliance with DST regulations.

     - Investors receive regular income distributions, while the sponsor provides periodic reports on the property’s performance.

4)  Disposition and Liquidation:

     - At the end of the DST’s term, the property is sold, and the proceeds are distributed to investors

     - Investors can choose to reinvest their proceeds into another 1031 exchange property, continuing the cycle of tax deferral.

Understanding these phases helps you guide your clients through the DST investment process, ensuring they maximize the benefits of their 1031 exchanges.

Conclusion

Delaware Statutory Trusts offer a compelling option for 1031 exchanges, providing passive income, professional management, and diversification benefits. By understanding the full cycle of DSTs, the regulations governing them, and the current market trends, you can better assist your clients in making informed investment decisions. For more detailed guidance on DSTs and 1031 exchanges, contact Bangerter Financial today.

Securities offered through Concorde Investment Services, LLC (CIS), member FINRA/SIPC. Advisory services offered through Concorde Asset Management, LLC (CAM), an SEC registered investment adviser. Insurance products offered through Concorde Insurance Agency, Inc. (CIA). [Insert DBA name here] is independent of CIS, CAM and CIA.