ABCs of the DST
By: Gary Justice
What is a DST?
The short answer is that it is the acronym for the Delaware Statutory Trust. It is also the structure of choice for today’s fractional-ownership Section 1031 tax-deferred exchanges.
Most DST programs (many include multiple properties) are sponsored by national real estate companies, and are offered through securities broker/dealers.
The DST, as a source of replacement property, is most often used by smaller, baby boomer investors for whom real estate is not their primary business. They might own a rental house or two, a multifamily property, or even a smaller office building or retail center. All require at least some, if not a lot, of active management. Reaching retirement age many of these investors are looking to cash in on their real-estate investments, tax-deferred of course, but they don’t want to just replace one set of active management headaches with another. You know, the tenants, toilets and trash! This scenario is what is seen as the “sweet spot” for a DST exchange. As you will read later in the article, the DST can also help other real estate investors address the traditional challenges of a 1031 exchange, particularly the challenges of replacement property identification.
Riding the real estate boom leading up to 2007, securitized replacement property programs rose from a small, niche market to peak at nearly $4 Billion1 in transactions in 2006. Then came the bust and a near-halt to all commercial real estate transactions.
Most of the pre-recession fractional-ownership programs were structured as Tenants in Common, or TICs. The credit crisis that hit in 2007, and the deep recession that followed, exposed some deficiencies of the TIC structure. A TIC program could have as many as 35 owners. Each owner had to be separately underwritten by the lender; each had to form a special purpose entity to hold their fractional ownership; and major decisions, such as lease renewals, refinancing and selling of the property required unanimous approval of the TICs. In bad times, it could be cumbersome, expensive and a risk to the investment. Post-recession, the DST structure addresses the deficiencies of the TIC, and, as a result, has universally become the entity of choice for fractional-ownership programs.
The DST structure for exchanges was just in its early stages prior to the recession. IRS guidance had come out in 2004, with Revenue Ruling 2004-86. Only a few major sponsors, including Inland Private Capital and Cole Capital, had begun offering the DST, usually for multiple-property offerings. Post-recession, however, all major sponsors use the DST almost exclusively.
According to Mountain Dell Consulting, a market research firm focused on the securitized 1031 exchange marketplace, the industry saw more than $1 Billion2 of securitized exchanges in 2015, well off the peak of 2006, but a significant resurgence from the depths of the recession. Recent industry estimates are that such exchanges will top $1.6 Billion this year. Mountain Dell further reports that 96% of the equity exchanged in 2015 came through DSTs. The few TICs were all from smaller sponsors.
Here’s Why DSTs Now Dominate the Marketplace:
No more active management headaches! In fact, Revenue Ruling 2004-86 mandates that only passive real estate qualifies for Section 1031 treatment in a DST. That means only net-leased properties, or real estate, such as apartments, that are subject to a master lease. Because of a prohibition against new leases during the life of the DST, except under a master lease, it puts a premium on the sponsor’s underwriting of properties and tenants.
The DST is simpler and less expensive than the TIC structure. The lender makes only a single loan to the trustee of the DST, not to each investor. The debt is completely “nonrecourse” to the investors. Because a DST is practically unlimited in its number of investors, the minimum exchange amount is usually just $100,000. Investors have only a single agreement to execute.
Because there is no Co-Ownership Agreement among the investors, as there is in a TIC, no DST investor is threatened by the actions of any other investor. Real estate owners who do not want to be in business with other partners are not. Their only agreement is with the trustee of the DST. The Revenue Ruling also prohibits any future capital calls!
DST Property Types
The Mountain Dell Consulting report for 2015 gives a breakdown of the property types that have been offered in DST exchanges. Apartments made up 56% of the equity exchanged last year. Retail, both single-tenant net-leased and multi-tenant made up 31%. Office, primarily medical office, at 10%, was the only other sector to register more than one percent.
Current trends indicate a potential up-tick in 2016 for some specialty sectors, including self-storage and industrial. However, you can expect master-leased apartments and net-leased retail to continue to be the most attractive for DST exchangers. Investors have the comfort of knowing that almost all real estate offered by the major sponsors is truly institutional quality. Sponsors do not even consider the smaller strip malls, multi-tenant office properties, and even raw land that proliferated in the TIC days.
Another trend from some of the larger sponsors is the increasing number of offerings with multiple properties in a single DST, partly to accommodate the rapidly growing demand. Inland Private Capital, which accounted for 42% of 2015’s transaction amount recently offered a portfolio of 17 self-storage properties in three states. ExchangeRight Real Estate, which raised the third highest amount of equity last year (PASSCO Companies was 2nd) has offered portfolios of more than 15 net-leased retail properties.
You are right, the traditional three-property ID rule will not cover the multiple-property offerings mentioned above. Danielle Brock, the exchange officer in the Bend, Oregon office of 1031 CORP., says multiple-property DSTs bring into play the 200% rule, “the exchanger may identify more than three properties as along as their combined fair market value does not exceed 200% of the market value of the relinquished property.”
Another feature of a DST exchange is that it may actually eliminate the need for identifying any property. Ms. Brock says, “If all the replacement properties are closed within the initial 45-day period, as is most often the case with DST properties, then the taxpayer is not required to provide a separate written ID at all.”
Other Uses of the DST
While we have identified the sweet spot for a DST exchange as the real estate investor looking for a more passive investment in retirement, I am seeing an increasing interest among other investors and their advisors in using the DST to solve some of the challenges of the traditional 1031 exchange. Not all real estate investors are in the business of real estate. In fact, most are not. They probably do not have access to ready sources of potential replacement properties and the resources for thorough due diligence. Throw in the time pressure of the 45-day identification period, and it is no wonder that Qualified Intermediaries send so much money back to their clients! So, while a full exchange into one, or more, DST programs may not be right for a particular client, it might be a preferable alternative in cases where…
- The seller/exchanger is having difficulty identifying suitable replacement property;
- The seller/exchanger is unable to place all of their sales proceeds into a selected replacement property. With a $100,000 minimum, a DST could make up the difference for a full exchange;
- Or… as a backup – just in case!
With guidance from IRS Revenue Ruling 2014-86, the Delaware Statutory Trust (DST) has evolved into a Section 1031 replacement property alternative with which investors and their advisors have become increasingly comfortable. The revenue ruling serves as an incentive for the sponsors of DST programs to underwrite, and offer, institutional quality real estate and tenants that can meet the IRS’ stringent restrictions, and to help real estate investors meet their goals of tax deferral, passive ownership, preservation of principal, and predictable cash flow.
1, 2 From Mountain Dell Consulting’s Annual Report on Securitized 1031s for 2015
Many thanks to guest author, Gary Justice, a registered representative of Conover Securities Corporation, in Bellevue, WA.
For a list of DST brokers, please contact your Exchange Officer.