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A Closer Look at the 7 Deadly Sins

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

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Paul Getty

Paul Getty is a licensed real estate broker in the state of California and Texas and has been directly involved in commercial transactions totaling over $3 billion on assets throughout the United States. His experience spans all major asset classes including retail, office, multifamily, and student, and senior housing. Paul’s transaction experience includes buy and sell side representation, sourcing and structuring of debt and equity, workouts, and asset and property management. He has worked closely with nationally prominent real estate brokerage and investment organizations including Marcus Millichap, CB Richard Ellis, JP Morgan, and Morgan Stanley among others on the firm’s numerous transactions. Paul also maintains a broad network of active buyers and sellers of commercial real estate including lenders, institutions, family office managers, and high net worth individuals. Prior to founding First Guardian Group/FGG1031, Paul was a founder and CEO of Venture Navigation, a boutique investment banking firm specializing in structuring equity investments made by institutions and high net worth individuals. He possesses over 35 years of comprehensive worldwide business management experience in environments ranging from early phase start-ups to multi-billion-dollar corporations. His track record includes participation in IPOs and successful M&A activity that has resulted in investor returns of over $700M. Paul holds an MBA in Finance from the University of Michigan, graduating with honors, and a Bachelor’s Degree in Chemistry from Wayne State University. Paul Getty holds Series 22, 62, and 63 securities licenses and is a registered financial representative with LightPath Capital Inc, member FINRA /SIPC. Paul is a noted speaker, author, and actively lectures on investments, sales, and management related topics. He is author of The 12 Magic Slides, Regulation A+: How the JOBS Act Creates Opportunities for Entrepreneurs and Investors, and Tax Deferral Strategies Utilizing the Delaware Statutory Trust (DST), available on Amazon and other retail outlets.

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