When used as a like-kind replacement property in a 1031 exchange, a Delaware Statutory Trust (DST) can create several potential benefits. Not only does a successful 1031 exchange allow you to defer your capital gains taxes and depreciation recapture, but DSTs also allow you to invest in professionally managed, institutional-quality commercial properties without the hassles that come with direct property ownership.
While IRS regulations allow DSTs to be used as replacement properties, there are several important restrictions, also known as the “7 Deadly Sins of DSTs.” This includes a prohibition that prevents a DST’s trustee from renegotiating current leases or entering into new leases unless the current tenant declares bankruptcy or becomes insolvent.
As a savvy investor, you may wonder how a commercial property can operate without the ability to engage in this critical aspect of property management. The answer lies in the DST structure, which typically includes either a Triple Net Lease or a Master Lease. Here’s a closer look at how it works.
Some DSTs acquire properties that already have a triple-net lease in place. This type of lease, also known as an NNN lease, is typically signed for a period of 10 years or longer and often has built-in rent escalations, eliminating the need for lease renegotiations.
Since the leases are already in force when the properties are acquired, the DST trustee is not entering into a new lease. This protects it from running afoul of IRS rules.
While this is a simple solution, it’s not practical when a DST owns properties that need to be frequently re-leased, such as apartments or self-storage properties. In this case, the trust can enter into a master lease agreement when the DST is formed.
A master lease agreement allows the DST trustee to lease the property to a master tenant, who is typically an affiliate of the DST sponsor. The master tenant is responsible for handling all property-level repairs and maintenance. This is typically done using a property manager, who may also be an affiliate of the sponsor.
The master tenant has the ability to sublease the property to others thus avoiding the prohibition on re-leasing while also allowing the property to continue operating as a trade or business.
It is important to note that Rev. Rule 2004-86 states that neither the master tenant nor any of its affiliates should own any portion of the DST. Therefore, if the sponsor or an affiliate operates as the master tenant, the sponsor should not retain an interest in the DST.
Master leases may be structured in two different ways, depending on the master tenant’s rent obligations. One is a fixed rent master lease and the other is a participating rent master lease.
When a DST is structured with a fixed rent master lease, the master tenant pays a fixed amount of rent to the DST. The master tenant is also required to pay all of the operating expenses related to the property.
Under a fixed rent master lease, either the DST or the master tenant may be responsible for paying the property’s insurance and real estate taxes. This is typically clarified in the lease agreement.
In a participating rent master lease structure, the master tenant typically pays a fixed amount of rent as well as an additional amount based on a percentage of the property’s gross revenue in excess of a baseline amount.
IRS rules clarify that the additional percentage can only be based on gross revenues and cannot be a sharing of net income. In addition, there are many other variables that can cause a participating rent master lease to draw unwanted attention from the IRS. For this reason, it’s important to carefully review the offering material and ensure you have a clear understanding of the lease structure’s potential risks and tax opinions before making a purchase.
Choosing the right DST for your needs can be a bit complex. When reviewing your options, it’s helpful to consult with a professional. The team at First Guardian Group will help you compare available DSTs and guide you through the 1031 exchange process. Contact us today to schedule a consultation.