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1031 INFORMATION - THE SEVEN DEADLY SINS

 

Internal Revenue Ruling 2004-86, which forms the income tax authority for structuring a Delaware Statutory Trust or DST transaction for use with a 1031 Exchange has prohibitions over the powers of the Trustee of the Delaware Statutory Trust of DST, which are known as the “seven deadly sins,” and include the following:

  1. Once the offering is closed, there can be no future equity contribution to the Delaware Statutory Trust or DST by either current or new co-investors or beneficiaries.
  2. The Trustee of the Delaware Statutory Trust or DST cannot renegotiate the terms of the existing loans, nor can it borrow any new funds from any other lender or party.
  3. The Trustee cannot reinvest the proceeds from the sale of its investment real estate.
  4. The Trustee is limited to making capital expenditures with respect to the property to those for a) normal repair and maintenance, (b) minor non-structural capital improvements, and (c) those required by law.
  5. Any liquid cash held in the Delaware Statutory Trust or DST between distribution dates can only be invested in short-term debt obligations.
  6. All cash, other than necessary reserves, must be distributed to the co-investors or beneficiaries on a current basis.
  7. Trustee cannot enter into new leases or renegotiate the current leases.

Many of the above are mitigated through the use of a master lease structure that allows, for example, day-to-day management and lease renegotiation which is seemingly prohibited in sin #7. And if one of the sins needed to be committed, there is an out.

The Delaware Statutory Trust of DST agreement may contain a provision which stipulates that if the Trustee determines the DST is in danger of losing the property due to its inability to act because of the prohibitions in the trust agreement (the seven deadly sins), it can convert the Delaware Statutory Trust or DST into a limited liability company (hereinafter referred to as the Springing LLC) with pre-existing agreed-upon terms.

The laws of the state of Delaware permit the conversion to a limited liability company through a simple filing with the office of the Secretary of State. The LLC will contain the same bankruptcy remote provisions as the DST for the lender’s benefit, but it will not contain the prohibitions against the raising of additional funds, the raising of new financing or the renegotiation or the terms of the existing debt or entering into new leases. In addition, it will provide that the Trustee will become the manager of the limited liability company. However, converting to an LLC would be a last resort, as the conversion would disallow an exchange upon disposition.

A 1031 exchange can offer investors distinct tax advantages, but as with any investment, it is not without risk. Consult with your investment advisor to determine if this type of investment is right for you.

1031 INFORMATION


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