When the IRS approved the Delaware Statutory Trust (DST) ownership structure as a 1031 replacement “like-kind” property option, the IRS conditioned their approval on 7 specific rules that must be followed by the trustee of the DST. The DST industry termed these rules the “7 Deadly Sins” since failure to adhere to them may lead to a reversal of the 1031 exchange.
Unfortunately, a simple error on the part of the DST trustee could result in a loss of favorable tax treatment and a potentially devastating tax obligation. To help ensure you make an informed decision when choosing your DST replacement property, familiarize yourself with the seven crucial mistakes DST trustees must avoid.
1. Future Capital Contributions
Once a DST is closed, it cannot accept additional contributions from new or current members. This rule helps protect the beneficiaries’ interest, since their investment gives them a certain percentage of ownership and additional borrowing could dilute their ownership percentages.
2. Loan Renegotiation or New Borrowing
A DST’s trustees may not renegotiate existing loans or secure new loans, as doing so could change the investment’s risk. Since DST beneficiaries don’t have voting rights, this rule protects them from changes that could impact them after they’ve made the purchase. However, there is one exception. New borrowing or renegotiation may be allowed if the current tenant declares bankruptcy or is insolvent or if the loan is currently in default or at risk of defaulting.
3. Lease Renegotiation or New Leases
A DST’s leases cannot be renegotiated. This rule often encourages trustees to secure longer-term leases, making the DST less risky and more secure for beneficiaries.
DSTs with short-term leases, such as apartments or storage, are often structured with a master lease to avoid this risk. In this case, the DST leases the properties to a Master Tenant who is allowed to enter into new subleases with underlying tenants. Also, trustees may be allowed to renegotiate leases if the current tenant is bankrupt or insolvent or is facing bankruptcy or insolvency.
4. Capital Expenditures
Capital expenditures are only allowed when needed to maintain the property and its value. This includes normal repairs and maintenance, minor non-structural capital improvements, and expenditures for improvements or repairs required by law. Allowing limited capital expenditures ensures the trustee can maintain the value of the property while also protecting the beneficiary’s investment from unnecessary spending on upgrades that may not create a sufficient return on investment. Substantial changes or redevelopment of the property are not permitted unless done to repair or replace portions of the property that may been damaged in a property casualty event.
5. Reinvestment of Sales Proceeds
All potential sales proceeds after payment of customary expenses must be distributed to the DST’s beneficiaries. This gives beneficiaries, rather than the trustees, the power to decide what to do with the capital they’ve earned. DST sponsors are not permitted to take a share of profits when the property is sold.
6. Failure to Distribute Proceeds
While it is acceptable to hold a reasonable amount of funds in reserve for repairs or unexpected expenses, all other potential earnings and proceeds must be distributed to DST beneficiaries on a timely, regular, and current basis each year.
7. Investing Liquid Cash
When a DST is holding cash that is not yet ready to be distributed, the only acceptable investment is a short-term debt obligation. These investment vehicles, also known as “cash equivalents,” are designed to keep cash safe until it is distributed.
Choose Your DSTs Wisely
While a 1031 exchange offers many potential benefits, choosing the wrong DST can potentially lead to significant financial losses. For help choosing your DST replacement property or more information about 1031 exchanges, contact First Guardian Group to schedule a consultation.