It is hard to believe but the Internal Revenue Code section known as 1031 is 100 years old this year. Along the way, the definition of like-kind property for real estate has changed over the years, the latest being in 2004 when Delaware Statutory Trusts (“DSTs”) were added as an acceptable replacement property.
Like most changes, DSTs took a while to catch on but now seem to be a significant part of the tax-free exchange portfolio. We thought this would be a good time to look back on Section 1031 and also explain the rules for using DSTs as tax-free exchange replacement property.
In the beginning, the Revenue Act of 1921 allowed both like-kind and non-like-kind exchanges (except for property with a readily realizable market value.) Congress was trying to avoid taxing “theoretical” gains and losses and promote domestic investment. By 1924, non-like-kind exchanges had been eliminated.
The first tax-deferred like-kind exchange – using a qualified intermediary and cash in lieu of actual property in the exchange – was approved by the Board of Tax Appeals in 1935.
Nothing much changed until 1979 when the Starker family did a five-year deferred like-kind exchange. The Internal Revenue Service (IRS) denied the tax deferral on the premise that 1031 required a simultaneous exchange. The Court, however, sided with the Starkers, pointing out that title didn’t have to be exchanged simultaneously in order for Section 1031 to apply (relying on a prior case called Redwing Carriers).
In 1984, in reaction to the Starker decision, Congress amended Section 1031 to add the 45-day identification and 180-day exchange periods. The IRS issued regulations in 1991 clarifying the calendar day rules, different kinds of exchanges and who could be a qualified intermediary.
Then things really take off. In response to new types of exchanges and new replacement property vehicles, the IRS began issuing Revenue Procedures and Rulings creating rules and safe harbors for taxpayers to follow. In 2000, the rules for reverse like-kind exchanges were released. In 2002, the IRS issued the Tenant-In-Common (“TIC”) property guidelines allowing for fractional ownership of property to be treated as like-kind. As lenders became hesitant to lend to TIC properties, particularly since they can’t lend to an entity, investors started to look to other fractional interest ownership structures. So, in 2004, the IRS released guidance on using DSTs as replacement property.
Oh, one last change before we move on to DSTs – in 2017, Congress again amended Section 1031, limiting it to exchanges of real property only. And one last point – Section 1031 treatment isn’t elective. If you structure the transaction as an exchange, there’s no recognition of gain or loss, whether you want to or not.
Using DSTs as Replacement Property
Often, owners who manage their own real estate grow tired of the day-to-day demands and wish to dispose of their rental assets. If such sellers want to avoid current gain recognition by entering into a Section 1031 exchange, they face the problem of finding suitable replacement property managed by others. Before 2002, this meant finding triple net lease properties with credit-worthy tenants. The risk is that a tenant may be credit worthy one day but not the next. While TIC interests allow for third-party management, the financing limitations create some difficulties.
DSTs, however, are exactly that – undivided interests in real estate managed by a trustee. The sponsor is actually the master tenant of the trust acquiring property for the benefit of the trust. The DST holds 100% of the interest in the property. Investors can either deposit exchange proceeds in the DST or buy DST interests.
There are restrictions on what a DST can do, namely:
- The DST may not accept additional contributions of assets
- The DST may not renegotiate leases or enter into new leases unless there is a tenant bankruptcy or insolvency
- The DST may not reinvest the proceeds from the sale of its property
- The DST may not purchase additional assets other than short-term obligations
- The DST may not renegotiate the loan terms and/or the loan may not be refinanced except for loan defaults arising from tenant bankruptcy
- The DST may not make major structural changes to the property
- The DST must distribute all cash, other than the necessary reserves, to the beneficiaries.
While transfers of the beneficial ownership interest in a DST are far easier than, for example, transfers of TIC interests, DSTs are still an illiquid asset. This isn’t really an impediment. After all, real estate itself is an illiquid asset and there isn’t a liquid asset available for exchange as replacement property.
Investing in DSTs requires the same level of due diligence as any other real estate joint venture:
- Is the DST properly organized to meet the requirements of the IRS Revenue Ruling?
- How experienced is the trustee/property manager?
- Are there sufficient cash reserves?
- Who are the tenants?
- What is the expense structure?
We at Friedman LLP have significant experience in evaluating DSTs as replacement property in Section 1031 exchanges. We welcome the opportunity to assist you as you explore potential investments in DSTs.