Understanding the Delaware Statutory Trust in regard to 1031 Exchange

This blog is a summary of information that I have compiled about DST in regard to 1031 exchange with an emphasis on a future project. In addition, I have added questions for myself and contributors to consider for 2025 deployment.

A Delaware Statutory Trust (DST) is a trust under Delaware statutory law. Investors in a Delaware Statutory Trust own a pro rata interest in the trust and have the right to receive distributions from the operation of the trust, either from rental income, or from the eventual sale of the property.

Through co-ownership, fractionally invest in larger properties. A DST expands the options investors have for properties to meet 1031 criteria. Finding eligible properties may also be less time-consuming because investors have more options for acquiring one or more properties.

To get a DST 1031 property, a Qualified Intermediary (QI) handles the exchange. The QI is a third party not affiliated with the seller or buyer & must hold and transfer the money to complete the exchange. The investor cannot directly receive the money from the first property sale.

Investors purchase units of beneficial interest and become beneficiaries of the DST’s operations. Investors have the following rights and responsibilities:

• the right to receive distributions. Based on the investors’ pro-rata interests in the trust, they have the right to receive distributions from the operations of the trust, either from rental income or from the eventual sale of the property. Operations can result in profits or losses, distributions are not guaranteed.

• No responsibility of property management. DSTs are operated and managed by trustees, removing any responsibility of day to day handling of the property’s operation or the eventual sale of the property.

• Not liable for the property. Investors do not have deeded title to the property, so they are not liable for the property.

• Incur tax responsibility. Since the trust is not considered a taxable entity, all the profits, losses, etc. are passed through directly to the beneficiaries.

Responsibilities of the trustees of a DST:
• Because the trust itself holds the deed to the property, the trustee’s liability for the property is limited.

• The trustee has the responsibility to make decisions on behalf of the trust for the benefit of the beneficiaries. This includes day to day operations as well as the sale of the trust’s assets.

• The trustee must adhere to the IRS Ruling 2004-86, which names the seven deadly sins that limit the DST’s trustee’s power.
An error can cause the DST to lose its qualification as a “suitable investment” for the purpose of a tax-deferred 1031 exchange.

1. Future Equity Contributions
   An investment in a DST gives the purchaser a certain percentage of ownership. After the DST is closed, any additional contributions by current or new investors would dilute the original ownership percentage. The IRS does not allow trustees to accept any additional equity contributions from new or existing investors after the DST is closed.

2. New Borrowing or Renegotiating Terms
   A trustee cannot take on additional loans or modify the terms of the current loans, this would change the risk of the investment. Since DST beneficiaries don’t have voting rights, this rule protects from actions that could significantly impact the investment's risk profile after they've made their purchase.

3. Reinvestment of Sale Proceeds
   The IRS also states that trustees may not automatically reinvest proceeds earned by a DST. They are to distribute these funds to the beneficiaries.

4. Capital Expenditures
   The "Capital Expenditures" rule states that trustees are allowed to make capital expenditures for 1) normal repair and maintenance, 2) minor, non-structural capital improvements, and 3) anything that’s required by law.

5. Liquid Cash Investments
   When the DST has liquid cash that is not yet ready for distribution, the trustee is only allowed to place it in short-term debt obligations. Since this is considered a “cash equivalent,” doing so poses no risk to the beneficiaries.

6. Cash Distributions
   While the DST trustee may keep some cash on reserve to cover necessary repairs or unexpected expenses, any excess funds must be distributed to the DST beneficiaries in a timely manner.

7. New Leases or Renegotiations
   IRS forbids trustees from entering into new leases or renegotiating current leases. This pushes trustees into less-risky, longer-term leases, ultimately creating a more secure investment for DST beneficiaries. If a tenant faces insolvency or bankruptcy, this rule is waived.

Considerations for the structure of the DST.

1. Needs to be rental property with long-term lease. Or land that generates an annual dividend.
2. Can it be mortgage backed loans as a package? Probably, not a good idea since this lacks the ability to add future loans after old loans pay out.
3. Can trustee be one of the investors? The majority (silent) investor would need to hold without 1031 implications to allow minority shareholders the flexibility to enter and exit through a buy-back. However, since there are no voting rights of investors, the trustee holds the ability to sale the property.
4. How are dividends disbursed, when?
5. Is there a buy-back close for minority investors with discount of original investment?
6. Can the buy-back be disappearing with an offset of the quarterly dividend?

When is the DST beneficial? For those who are exiting property and need a place to park the 1031 with the ability to cash out of the 1031 exchange into a new property in a relative short period of time.

How does this generate revenue for the trustee? Does this add capital to use elsewhere or does it require the retention of capital for buy-backs?

Does the DST exceed 4% return and does it require too much management time? Is loan service on $10M easier and just as beneficial?

IMPORTANT NOTE: The DST is selling securities. Securities, even private placement securities, are regulated by SEC. The DST can use rule 506C which allows marketing to accredited investors only. In addition to marketing, the DST can only accept investments from accredited investors, whether a part or not part of a 1031 exchange. Accredited investors need net worth $1 million or earn $200K per year.
Reference link in regard to private placements https://www.realized1031.com/blog/understanding-private-placement-offerings-and-delaware-statutory-trusts-dsts

ESTABLISHING THE DST ALTERNATIVE
Establishing a DST is difficult due to rule 506C that the investors must be accredited investors.
However, Qualified Intermediaries are not regulated. Establish a QI which does not require vetting of the 1031 participant. Requires trust account. Stick to 3 property rule. But can one of the 3 be an established DST? If so, this avoids boot. However, the DST needs to allow quick entry and exit for most 1031 participants. Is there a referral fee for the DST replacement?

USING QI IN PARTNERSHIP WITH PRIVATE LENDING
Scenario: Private lending to investor. Investor buys fix and flip. (revenue stream 1: origination fee, interest. Potential revenue stream 2: buyer broker commission)
Investor renovates.
Investor prepares to sell fix and flip. (Potential revenue stream 3: Seller broker commission)
Investor engages QI for 1031 exchange. (Revenue stream 4: QI fees)
Investor sells property. Money to QI. Private lender paid in full. Equity and profit held in escrow.
Investor has 45 days to establish up to 3 replacement properties. One or any combination of the three. Total purchase must be in excess of sales price of original property. One of the 3 could be DST to avoid boot. (Potential Revenue stream 5: DST referral.)
Investor enters contract to purchase properties. Purchase must occur within 180 days of sale of original property or the date of tax due, whichever is sooner. However, tax due date can be extended by filing tax extension, but no more than 180 days total. (Potential revenue stream 2: Buyer broker on replacement properties)
Investor borrows from private lender to complete purchase(s). (Revenue stream 1,repeat).

What are the revenue streams on each deal?

1. Private lender origination fee and interest. 2% and 14%
2. Buyer Broker commission: 3%
3. Seller Broker commission: 3%
4. QI Fees: Flat rate $1250 per property THE QI CANNOT HAVE SERVED OR CURRENTLY SERVE IN THE BROKER OR BANKER ROLE! Here's the reference https://www.realized1031.com/download-file/QI-ebook
5. DST referral, placement fee: Unknown
   Consideration: All clients must participate in all phases. This generates 10% revenue stream plus 14% interest. 24% ROI. HOWEVER< CANNOT HAPPEN DUE TO QI CANNOT BE BROKER OR LENDER

2nd Consideration: When would you want to establish a DST? When there is one large qualified investor that has high frequency of 1031s? I.E. Sale office complex to DST. This is completed as investor owns office complex. Investor sales office complex to DST while simultaneously purchasing all of the DST securities. The investor needs to be 506C. The investor can now sell a portion of the DST securities to investor 2 who has a high frequency for 1031 exchanges. Investor 2 can liquidate a portion of the DST investment whenever he identifies his next purchase for 1031 exchange. DOES HE NEED TO LIQUDATE ALL OF IT? PRBOABLY NOTE SINCE THE TOTAL AMOUNT OF NEW PURCHASE AND THE REMAINING DST ARE IN EXCESS OF THE ORIGINAL INVESTMENT? This might be a good fit for Prime Acres.
Is there benefit in this model? Investor 1 has to hold cash to repurchase whenever investor 2 needs this to happen. Investor 1 could have sold the asset and reinvested money separately. Is that a better ROI?
Additional reference to read https://cdn2.hubspot.net/hubfs/5468919/offers-for-download/ebook-tax-deferral-strategies-utilizing-the-dst.pdf