Delaware Statutory Trust Risks
As with any investment, there are potential risks of Delaware Statutory Trust investments for 1031 tax deferred exchange.
Although Delaware Statutory Trust investments have many advantages, they like any investment, are not without risks and are not a good fit for all investors .
As a real estate investor it is important to review the potential benefits as well as potential risks prior to investing.
Disadvantages of Delaware Statutory Trust
Potential risks associated with Delaware Statutory Trusts (DST) investments include:
General real estate risks and market also apply to 1031 Exchange DST. There can be no assurance that a property will perform as projected and Delaware Statutory Trust are subject to economic volatility, tenants not paying their rent timely, and other traditional risks of owning, selling, and operating real estate.
Investors Do Not Hold Title
1031 Exchange DST investors do not hold title to the investor but rather own beneficial interests in the trust and the sponsor controls the selling and managing of the property. The Delaware Statutory Trust owners have limited control over the investment and are reliant on the sponsor.
A Delaware Statutory Trust interest is an illiquid investment and there is no current active secondary market for selling your interest.
Fees and Expenses of each offering should be carefully evaluated. Multiple owner offerings typically have additional expenses to owning real estate on your own and these fees should be weighed against specific capital gains tax liability. All investors are encouraged to have their tax and legal counsel advise them on taxes including any federal and state capital gains taxes, depreciation recapture and the recent 3.8% Medicare tax, which could be applicable.
Delaware Statutory Trusts are structured according the Revenue Ruling 2004-86. Corcapa and DAI Securities, LLC typically work with sponsors and properties that have “should” level tax opinions regarding 1031 exchange tax compliance but its possible the IRS would rule unfavorably on a 1031 Exchange DST offering and this could result in back and immediate tax liability.
Potential for Property Value Loss
All real estate investments have the potential to lose value during the life the investment.
Potential for Foreclosure
All financed real estate investments have the potential for foreclosure.
Reduction or Elimination of Monthly Cash Flow Distributions
Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is a potential for suspension of cash flow distributions.
Seven Deadly Sins
The enabling IRS revenue ruling which forms the basis for a DST transaction in a Section 1031 exchange program has prohibitions on the powers of the trustee, which are built into the Trust Agreement and have become known as the “seven deadly sins”. They are:
- Once the offering is closed, there can be no future contributions to the DST by either current or new beneficiaries.
- The Trustee cannot renegotiate the terms of the existing loans nor can it borrow any new funds from any party unless a loan default exists as a result of a tenant bankruptcy or insolvency.
- The Trustee cannot reinvest the proceeds from the sale of its real estate.
- 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.
- Any reserves or cash held between distribution dates can only be invested in short term debt obligations.
- All cash, other than necessary reserves, must be distributed on a current basis, and
- The Trustee cannot enter into new leases or renegotiate the current leases, unless there is a tenant bankruptcy or insolvency.
Because of the Delaware Statutory Trust restrictions the best types of real estate for a DST are Master Lease transactions where the Master Tenant takes on all the operating responsibilities or a Triple Net/Net Long Term Lease with a financially stable tenant. Additionally, it is prudent with 1031 Exchange DST to have sufficient upfront and ongoing reserves, as well as a plan for a sale prior to the maturity of a loan.
Additionally, there is a “Springing LLC” provision option which could convert the trust to a limited liability company to solve property issues. However, this could prevent future 1031 ability and adversely affect the value of their investment.
One additional approach to give the Lender comfort is to place an operative provision in the Trust Agreement that if the trustee determines that the DST is in danger of losing the Mortgaged Property due to tax related restrictions on the trustee’s ability to act, (the seven deadly sins), it can convert the DST into a limited liability company (the “Springing LLC”) with a Lender-approved operating agreement. Delaware law permits the conversion by what is basically a simple election and which does not constitute a transfer under Delaware law. The “Springing LLC” will contain the same SPE and bankruptcy remoteness 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 renegotiation or the terms of the existing financing or entering into new leases. In addition, it will provide that the trustee (or Sponsor) will become the manager of the LLC.
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