The Seven Things a DST Cannot Do, and the Escape Hatch That Costs You

A Delaware Statutory Trust works as 1031 replacement property for one reason: the IRS decided in Revenue Ruling 2004-86 that a beneficial interest in such a trust can be treated as a direct interest in real property, provided the trust stays genuinely passive.

To stay passive, the trustee must not do certain things. Those restrictions are what make your interest exchangeable, and they are also what leaves a DST unable to respond when a property runs into trouble.

What are the restrictions?

The commonly cited list, drawn from the ruling, is that once the offering is closed the trustee generally cannot:

• ›Accept new capital contributions from existing or new investors
• ›Renegotiate the terms of existing debt or borrow new funds
• ›Reinvest sale proceeds rather than distributing them
• ›Make capital expenditures beyond normal repairs, minor improvements and those required by law
• ›Invest cash held between distribution dates other than in short term obligations
• ›Distribute anything other than cash held, after reserves, on each distribution date
• ›Enter into new leases or renegotiate existing ones, except in limited circumstances such as tenant bankruptcy or insolvency

The practical effect is that a DST is designed to hold a property in a fixed state until it is sold.

Why do the restrictions exist?

Because an entity that actively manages a business looks like a partnership, and partnership interests cannot be exchanged under Section 1031. By preventing active decisions, the ruling supports treating each investor as owning a direct interest in real estate.

Every restriction is therefore protecting your ability to have exchanged into the trust in the first place.

What happens when a property needs something the trust cannot do?

This is the weakness of the structure. If occupancy falls sharply, a major tenant leaves, the loan needs restructuring or a large capital expense arises, the trustee has few options. It cannot raise money from investors or renegotiate the loan.

Without a mechanism to respond, the property could be lost. So nearly all DST offerings include one.

What is the springing LLC?

A provision allowing the trust to convert into a limited liability company if circumstances threaten the property.

Once converted, the entity is no longer bound by the restrictions. The manager can negotiate with the lender, raise capital, sign new leases and make decisions that the trust could not.

What does conversion cost the investor?

Ownership changes character. LLC interests are generally treated as partnership interests for tax purposes, and partnership interests cannot be exchanged under Section 1031.

An investor who intended to keep deferring gain by exchanging out of the DST when it sold may find that route closed. The tax consequences depend on the facts and need advice at the time.

Investors also lose the notional protections the restrictions provided, although in practice those restrictions were what created the problem.

Who decides whether to convert?

The trustee or manager, under the terms of the trust documents. Investors do not usually vote. That is consistent with the passive structure, but it means a decision with significant tax consequences for you may be taken without your involvement.

What should you ask before investing?

• ›What circumstances trigger a conversion to an LLC?
• ›Who decides, and is there any investor notice or consultation?
• ›Has the sponsor converted any prior offering, and what happened to investors?
• ›What is the loan maturity date relative to the projected hold?
• ›What reserves exist for capital expenditure and vacancy?

Does this mean DSTs are risky?

It means they are rigid. Rigidity works well when a property performs as expected, which is why sponsors choose stabilised assets with long leases. It works badly when something goes wrong.

Understanding that trade off is the point. A DST is not a managed fund that adapts. It is a fixed structure holding a specific property, with a defined plan and an emergency exit that carries tax consequences.

How do sponsors work within the restrictions?

Because a DST cannot adapt, sponsors try to remove the need to adapt. That shapes which properties appear in offerings.

• ›Long leases with creditworthy tenants, so leasing decisions are not needed during the hold
• ›Recently renovated or newly built assets, so major capital expenditure is unlikely
• ›Fixed rate debt with a maturity beyond the projected hold, so refinancing is not required
• ›Funded reserves set aside at the outset, because more cannot be raised later

When you review an offering, those four features tell you how much the restrictions are likely to matter. A property with a short remaining lease, deferred maintenance, floating rate debt or thin reserves is one where the trust may need flexibility it does not have.

What does this mean for diversification?

Because each trust is rigid and its outcome depends on one property or a small group, spreading capital across several offerings from different sponsors, in different asset types and locations, reduces the chance that one problem property determines your result. The trade off is more paperwork and smaller positions in each.

What to do first

Read the section of the offering documents dealing with conversion rights, then ask the sponsor directly whether any previous offering has been converted. Consider spreading capital across several offerings rather than one, so a single problem property does not determine your whole outcome.

Nothing here is tax, legal or investment advice. DST interests are securities offered to accredited investors only through licensed broker dealers and definitive offering documents, and investing involves risk including loss of principal.