Investors looking to reinvest profits from the sale of an asset know that it’s a delicate process. After all, they don’t want to expose their earnings to capital gains taxes if they are planning to reinvest the money quickly. However, investors often find themselves switching strategies or opting to invest in other classes of real estate. That’s where 1031 exchanges, so named for the section of the tax code that enables them, enter the picture. This strategy allows investors to defer capital gains taxes, provided they use the money from the sale of a property to invest in another.
In the early 2000s, a legal structure, known as “tenancy in common,” or TIC, was a leading investment vehicle for 1031 exchanges into commercial real estate projects. When investors are tenants in common, they jointly own the property. It is similar to joint tenancy, often used by couples and families to hold title to real estate. A tenancy-in-common is a fractional ownership arrangement in which investors pool their capital to acquire a real estate asset. It can give investors access to projects that they could not afford, as well as the ability to diversify their real estate holdings.
TIC investments can be highly advantageous. TIC investors in viable projects managed and operated by reputable sponsors can reap the benefit of market appreciation, and on sale, defer gains by completing a section 1031 exchange into another property. In a down market, however, TIC investments can be problematic. The tax ruling that set the stage for TIC investments through 1031 exchanges – Internal Revenue Ruling 2004-86 – permitted up to 35 co-TICs, each of whose consent is ordinarily required for transactions like leases and sale. The unanimity requirement enabled individual investors to withhold consent to leverage an outsized return at the expense of other TICs.
When the recession hit in 2008, TIC investments were hit along with the rest of the commercial real estate market. TIC investments often were difficult to restructure because of in-fighting by co-owners, who often bristled at the terms required to bring in new capital and save a project. Enforcement of lender remedies also was complicated by the number of owners and borrowers involved, each of whom, for example, could file bankruptcy. When the economy recovered, lenders shied away from transactions involving TICs in favor of deal structures that had a singular owner and borrower.
An alternative to TIC investments is the Delaware statutory trust (“DST”). Like TICs, DSTs are a form of fractional ownership that qualifies for 1031 exchange treatment. Investors in a DST receive beneficial interests in the trust, which is managed by a trustee. Generally, financing is more available to DSTs than TICs. Because the trust owns the property (versus multiple TICs), lenders have to deal with only one borrower.
In 2004, the IRS issued Revenue Ruling 2004-86, which sets forth requirements that must be met for an investor to complete a section 1031 exchange into a DST. The key limitations under Revenue Ruling 2004-86 for a DST to qualify for a 1031 exchange are often referred to as the “Seven Deadly Sins.” The Seven Deadly Sins of DSTs are as follows:
- Once the offering closes, 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 related to the property: (a) for normal repair and maintenance, (b) for minor non-structural capital improvements, and (c) if 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.
In light of the Seven Deadly Sins, it is critical to work with a sponsor you can trust. The usual recourse for a DST to avoid committing one of Seven Deadly Sins is to convert to a limited liability company (“LLC”), which isn’t subject to the same restrictions. The downside to converting to an LLC is the potential loss of your ability to exit your investment through another 1031 exchange. Working with a sponsor that completes extensive due diligence before acquiring a real estate asset, and retains experienced management once the property is placed in a DST, reduces your downside risk.
Contact Virtua Capital today to learn more about whether a Delaware Statutory Trust is right for you.
Not an offer to buy nor a solicitation to sell securities. All investing involves risk, and past performance may not be indicative of future results. You should consult with your financial, tax, or other advisors to determine whether an investment is suitable for you.