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Navigating the complexities of DST’s.

Let’s start with the basics. What is a DST?
DST is an acronym commonly used for the term Delaware Statutory Trust. In short, a DST is a legally recognized trust established under the laws governing corporations in the state of Delaware. A DST may be formed to hold title to real property for investment purposes or to conduct a business for profit carried out by one or more trustees for the benefit of the parties that own beneficial interests in the trust.

How can a DST play a role in a tax-deferred exchange (1031 exchange)?
On July 20, 2004, the IRS released guidance that created the framework for real estate investors to defer taxable gains from the sale of rental property by reinvesting in real property held inside of a DST. Revenue Ruling 2004-86 provided a set of guidelines that the trust must follow to provide investors with a passive investment strategy that still falls under the category of “like-kind” real estate under 1031 exchange guidelines.

What are some of the drawbacks of investing in a DST?

1. Lack of Control
If you MUST be in the driver’s seat when it comes to all facets of the operations of your rental properties, I can safely say that DSTs are NOT going to be a good fit for you. DSTs are an extremely passive investment vehicle. As a beneficial interest owner in the trust, you are entitled to many of the benefits of investment property ownership EXCEPT the ability to drive the ship yourself. Each DST has a Trustee that is tasked with making all the business and operating decisions on behalf of the trust. As an investor, you are welcome to engage with the trustee to express your opinions and perspective but ultimately the final decision for all matters impacting the property lies with the Trustee.

2. Inability to modify existing leases, refinance the loan or conduct a capital call.
Please allow that sentence to sink in for a moment. You MUST understand that the DST is a very rigid structure. Once the initial capital stack (equity down payment, acquisition mortgage and any reserves) is established the trustee and the investors are unable to make any adjustments to it. Additionally, the DST and the trustee acting on its behalf are generally unable to renew existing leases or execute new leases with prospective tenants as vacancies arise. Those two constraints are particularly important to grasp to gain an understanding of how the relationship between the DST and the Master Tenant impacts the investment. Read below to learn what a Master Tenant is.

3. No readily available secondary market for a beneficial interest in a DST.
While DST investors may be able to transfer their interest to a 3rd party, the beneficial interest itself should be viewed as extremely illiquid given that no readily available secondary market exists for the purchase or sale of interests. An investor should only purchase an interest in a DST if they are prepared to hold that investment for the entire length of the business plan which could be upwards of 7-10 years.

With those drawbacks, why would I ever consider investing in a DST for my tax deferred exchange?

  1. No need to take on the burden of the Terrible T’s of property management – Tenants, Termites, Toilets, Trash, and Telephone calls at all hours.
  2. Access to investment properties that are outside of high priced, heavily taxed and heavily regulated markets like you may see in California.
  3. Non-recourse, off-balance sheet financing that can be used to satisfy debt replacement requirements from your relinquished property.
  4. The opportunity to diversify your portfolio from a single property in a single market to a portfolio of geographically diverse, professionally managed properties due to the relatively accessible $100,000 minimum equity commitment required for each DST.
  5. Reserves for capital improvements, deferred maintenance and operational needs are established at the inception of the DST. These reserves may be used to smooth out operating fluctuations and pay for major repairs or upgrades so that those funds don’t have to come out of operating cash flow assuming that reserves have not been depleted.
  6. All of the benefits of investment property ownership including but not limited to: potential monthly cash flow, regular operating reports, annual forward looking budgets, annual tax reports to be easily included in your Schedule E and the potential for depreciation to shelter the cash flow received from current taxation.
  7. Economies of Scale – Most DSTs are formed to acquire professionally managed properties that would be generally out of reach financially for most individual investors and families.

Questions you need to ask yourself before the sale of your relinquished property sells:

What is the tax liability from the sale if I choose to cash out and take receipt of the proceeds rather than exchanging?
First things first, before you head straight down the path of a 1031 exchange, it is imperative that you weigh the potential tax savings from the exchange against the potential benefits that come with cashing out after the sale to create more liquidity in your portfolio and/or diversify your portfolio with new investments outside of rental property. Every investor should first ask their tax preparer or CPA for an estimate of the tax liability if they were to sell the property and not move forward with a tax deferred exchange. Only then can you weigh the benefits of the tax deferral versus the potential enhanced liquidity and diversification that comes with cashing out and paying the taxes.

Could my financial situation benefit from using the sale to add to the liquidity in my portfolio?
A 1031 exchange should be viewed as a part of your overall financial plan. Under that lens, it is important to look at how much liquidity you have in your portfolio before the property is sold. Investors must always be mindful of the need to have an appropriately sized cash safety net as well as some liquid assets that can be accessed in the event that something unforeseen occurs or an extraordinary investment opportunity presents itself that would require quick access to cash assets.

Is a partial exchange something that I should consider?
A partial 1031 exchange is a strategy that allows the investor to defer a portion of the capital gain and depreciation recapture while also creating some new liquidity. This is accomplished by allocating some of the sale proceeds to a replacement property and then taking constructive receipt of the remaining sale proceeds. Taxes are only paid on the proceeds that are received thus reducing the overall tax burden associated with cashing out completely while also creating more flexibility in your financial world by adding the after tax cash received to your non-real estate portfolio.

Questions you should be asking about DSTs that you may not even know to ask:

What is a Master Lease and how does it impact my cash flow?
In order to satisfy some of the structural constraints of the DST, the entire property is typically leased by the Trust as the Landlord to a single tenant that is generally made up of a newly formed entity affiliated with the investment sponsor. The Master Lease is the agreement that governs the relationship and contractual obligations of both the Master Tenant and the DST. The Master Lease generally specifies which party is responsible for paying for debt service, controllable and uncontrollable property operating expenses, capital improvements, and outlines any arrangement to split the operating cash flow between the DST investors and the Master Tenant.

What is a Master Tenant?
A Master Tenant is generally a newly formed entity that is affiliated with the investment sponsor created for the sole purpose of leasing the entire property from the DST investors. The Master Tenant assumes the responsibility for subletting each of the individual apartment units or retail spaces to the tenants that actual live or conduct business at the property. The Master Tenant is generally responsible for collecting the rental revenue, paying for typical operating expenses, and making monthly cash flow distribution pursuant to the terms and thresholds outlined in each master lease agreement. Please note that distributions are not guaranteed and are contingent upon the successful operations of the property.

How is the Master Tenant capitalized and what financial incentive or liability does the Master Tenant have when it comes to the profit or loss generated by the property?
This is a very important question to ask before making a DST investment decision because the answer will demonstrate whether or not the sponsor, through their control of the Master Tenant, has any of their own capital at risk in the investment. Many Master Tenants are brand new entities that consists of nothing but a corporate shell and the master lease with the DST when they are created. Most but not all DST sponsors make sure to put some of their own capital into the Master Tenant to provide a base level of cash or a demand note to capitalize the newly formed company. Without any assets from the sponsor to capitalize the Master Tenant, the DST investors run the risk of the Master Tenant not being able to live up to their financial obligations under the Master Lease Agreement. While demand notes may be called by the Master Tenant to help meet its obligations under the Master Lease, there is no assurance that the amounts will be sufficient to pay rent or fund its obligations or that the sponsor will be able to meet the demand note funding obligation.

What experience does the property and asset manager have with this type of property? Do they have any experience investing in this geographic region?
As the saying goes in real estate, it is all about location, location, location. In the world of DSTs, it is equally as important to gauge the level of experience the investment sponsor has well as any third-party asset/property managers have with a particular asset class. There are distinct operational differences between an office building, an apartment complex, a self-storage facility, and a student housing complex. Each type of property has its own set of operational nuances that your investment sponsor and management teams should have firsthand experience with.

The second layer of this question should be inquiring about whether the investment sponsor and management have experience in different market and economic environments. The follow up question is of paramount importance today given that there are several investment sponsors that only recently entered the 1031/DST sponsorship business. The last few years (prior to the pandemic) were the equivalent of a rising tide that lifted most if not all ships. Investors should inquire whether the sponsor has experience managing the type of property in question during the Great Financial Crisis of 2008-2010 or other times of economic turmoil. There can be a lot gleaned about the sponsor’s competency to manage in both good time and bad by asking how they and their investors fared during the last recession.

How much is being set aside in reserves for future capital expenditures and to support operations in the event of a disruption in performance at the property?
Given that DSTs cannot raise any outside funds for capital improvements or to cover operating shortfalls, the need to adequately reserve cash at the outset of the investment is paramount. Prior to the acquisition of a property, the investment sponsor generally hires a third party to conduct a Property Condition Report and/or a Needs Assessment to estimate any near-term repairs that need to be addressed shortly after purchase as well as how much it will cost in today’s dollars to maintain the property’s aesthetic and structural integrity during the entire duration of the business plan.

The Needs Assessment specifically identifies how much capital might be required to ensure the property looks and functions as it does today seven to ten years down the road. Additionally, many sponsors set out to upgrade the property after acquisition by renovating unit interiors, upgrading the common areas or adding amenities with the goal of raising rents. It is imperative that the sponsor structures the DST from the outset with enough cash reserve to address the potential future needs to avoid having to syphon cash flow away from investors to fund those expenses.

Does the sponsor have an economic stake in the performance of the property – both positive and negative?
This question speaks to how the Sponsor/Master Tenant is financially motivated and whether those motivations are working in concert with those of the DST investors. If the Master Tenant shares in the financial liability for certain expenses or in the windfall that comes with rental revenues outpacing expectations, there is likely an alignment of interests between the Master Tenant and the DST investors. If the Sponsor or Master Tenant do not share in the positive or negative fluctuations of the property’s performance, they may not be as motivated to maximize the investment’s overall value which could strain the return and thus impair the experience associated with the investment.

What is the difference between Controllable and Uncontrollable Operating Expenses?
Controllable expenses are all the operating expenses of the property that can be controlled to varying degrees by the management team. They include but are not limited to landscaping, maintenance, make-ready, administrative, and employee expenses. Through diligent management those items of expense can be controlled in various ways by the management team. Conversely, uncontrollable expenses like real estate taxes, property insurance, and utilities are expenses that are often outside of the control of the management team. Understanding the difference between the two types is important especially when it comes to gaining a proper understanding of the Master Lease Agreement and the relationship between the Master Tenant and the DST investors.

What happens if the DST needs to refinance the loan, modify the Master Lease Agreement, or raise additional capital to stabilize the property?
If you have been investing for any length of time you likely already know that everything does not always go according to plan. There are bound to be circumstances where a business plan just does not hold up under the weight of unforeseen events and modifications must be made to keep the property and ultimately your investment solvent. In the event that any of the situations mentioned above occur, the DST will likely need to be transferred into a more flexible ownership structure so that the loan or Master Lease can be modified or a capital call can be conducted to right the ship.

If this comes to pass, a Springing LLC may be formed to replace the DST as the legal owner of the property. The DST investors then become members of the newly formed LLC in the same percentages as they held in the original ownership structure. Once the new entity is in place, the manager of the LLC can make the modifications necessary to satisfy the issue at hand and hopefully return the property to solid footing. The main drawback of the transfer distribution to a Springing LLC is that investors may no longer be able to conduct a 1031 exchange to defer their embedded tax liability when the property is sold. Investors should seek guidance from a tax professional to understand all the implications of the DST being transferred to a Springing LLC.

The Life Cycle of a DST

  1. Sponsor Due Diligence Phase: Investment sponsor locates the targeted investment property.
  2. DST Formation Phase: Investment sponsor creates the DST.
  3. Capital Stack Formation Phase: Investment sponsor secures long-term financing to acquire the property, contributes the down payment equity, and establishes a plan to fund the operating and capital reserves for the DST.
  4. Offering Document Phase: Investment sponsor creates a private placement memorandum that includes a number of important elements for investor due diligence including but not limited to a market analysis, financial projections, and a detailed discussion of the risk factors inherent to the investment.
  5. Investor Due Diligence Phase: Investors seeking a tax deferred exchange work with a financial advisor to weigh the benefits and drawbacks of each potential DST investment before determining whether the offering is suitable.
  6. Purchase Phase: Prospective investor completes a Purchase Agreement and Purchaser Questionnaire and then works with their accommodator (also known as a qualified intermediary, and is someone who facilitates your 1031 exchange) to provide consent to fund and close the investment in the DST on their behalf.
  7. Investment Closing Phase: Sponsor closes the investment on behalf of the investor, providing a closing package that includes the percentage of the DST being purchased and the allocation of both debt and equity.
  8. Ownership Phase: Investors generally may receive monthly cash flow, quarterly operating reports, forward-looking annual budgets, and year-end tax reporting.
  9. Marketing Phase: Trustee of the DST determines when it is most appropriate to sell the property. At that time, they generally notify the DST investors of their intent to market the property on their behalf.
  10. Disposition Phase: The property is sold and each DST investor is entitled to once again determine whether they want to conduct a 1031 exchange, cash out and pay the taxes to create liquidity, or follow some path that includes a combination of the two strategies.

Am I responsible for filing a state tax return in the state that the DST is located?
Yes, if you purchase an investment property outside of your home state you must file a state income tax return for the state where the property is located. Any taxes paid to that state are deductible against any taxes that would be payable to your home state. For example, a CA taxpayer purchasing a DST interest in a property in CO would have to file a return in CO to report all income generated in that state during the year. Since CA marginal tax rates are higher than CO, the investor would still need to report the income to the Franchise Tax Board in CA but can deduct the taxes already paid to CO against the any taxes due to CA.

The exception of course is when the DST or other rental property is in a state that does not have a state income tax like WA, TX, NV, FL, WY, SD, & AK. The income from the DST would only have to be reported in the investor’s home state.

*This information is for educational purposes only and does not constitute an offer to purchase a Delaware Statutory Trust (DST). This material is not to be interpreted as tax or legal advice.
Please speak with your own tax and legal advisor regarding your particular situation.

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