Tax deferred exchanging has been around a long while. In fact in some form, it has been with us since the 1920s. However, the difficulty associated with completing an exchange from then up until the late seventies, was directly related to those issues which arose around having to complete every transaction simultaneously. That’s right, up until the case law which came out of the Starker decisions, every exchange had to be done where all the transfers were completed on the same day. Not an easy task at all. But what happened with the Starker situation was this: The Starker family sold some timberland to Crown Zellerbach. And, instead of receiving cash in the sale, they took a credit on the books of the company. Then, over the course of about five years, as the Starker family found replacement property they wanted, Crown Zellerbach would buy it and have it deeded to them and applied against their credit on the company books.
Well, you can imagine that the Internal Revenue Service was unimpressed with this entire approach so they disallowed it and everything ended up in tax court. But interestingly enough, what actually arose from all the proceedings was that the delayed exchange concept was upheld. Granted, not every single of the Starker transfers were found to be compliant. But enough were, so that for the period between the Starker case law rulings and 1984, delayed exchanges could actually be completed legitimately in the circuit which heard the original case.
Well obviously, if you no longer had to close everything simultaneously, you’d do a delayed or deferred exchange yourself. So naturally, exchange volume increased. In fact it increased to such an extent, that the Internal Revenue Service went ahead and codified delayed exchanging in 1984 simply in an effort to get some control around the whole process. For instance that’s where our 180 day time frame and identification rules came from. Since then we’ve gotten rules for reverse exchanges which make them easier to easier to complete as well as several Revenue Procedures and other forms of Guidance that deal with many other forms of exchanging. Everything from the programmed exchanging of fleets of cars and trucks to the partial exchange of assets which are influenced by various other sections of the Code.

What Is A Tax Deferred Exchange?

A tax-deferred exchange represents a simple, strategic method for selling one qualifying property and the subsequent acquisition of another qualifying property within a specific time frame. Although the logistics of selling one property and buying another are virtually identical to any standard sale and purchase scenario, an exchange is different because the entire transaction is memorialized as an exchange and not a sale. And it is this distinction between exchanging and not simply selling and buying, which ultimately allows the taxpayer to qualify for deferred gain treatment. So essentially, sales are taxable and exchanges are not.

What Is Internal Revenue Code Section 1031?

Because exchanging represents an IRS recognized approach to the deferral of capital gain taxes, it is important for us to appreciate the components and intent underlying such a tax deferred or tax free transaction. It is within Section 1031 of the Internal Revenue Code that we find the core essentials necessary for a successful exchange. Additionally, it is within the Like-Kind Exchange Regulations, previously issued by The Department of the Treasury, that we find the specific interpretation of the IRS and the generally accepted standards and rules for completing a qualifying transaction.

What Is The Definition Of Like Kind Property?

Any tax deferred exchange completed pursuant to Section 1031 needs to involve like kind properties. So what is the definition of
like kind? Well, first, it is important to remember that like kind refers more to the way a property is used rather than the way it looks. For instance, the typical single family detached home can be both a personal residence or an income property, right? Okay, so then the definition for like kind essentially boils down to you needing to use your property in one of two ways. And those two methods which make up like kind are property held for investment, and property held for a productive use in a trade or business. Basically property held for income. So as you are out looking for candidate replacement properties, make sure your use of that new property will fit within one of those two categories. And that is the definition of like kind.

What Are The 1031 Exchange Time Constraints?

There are only a few rules which are critical to making your exchange qualify and one of the most significant is the allowance of time in which you have available to complete a delayed or deferred exchange. So here are the two time sensitive rules you need to remember.
Okay, first important time rule. You have a total of 180 days in which to sell your relinquished or exchange property and actually buy and close on your replacement property or properties. That is called the exchange period. Also, if you buy more than one, make sure the last one you close is still within that 180 day window or it won’t qualify. Now often you’ll hear a qualifier or caveat regarding the 180 day exchange period which can be very important. And that is this: you actually have 180 days or whenever your tax return is due, which comes first. So what does that mean? If you close your relinquished or exchange property late in the year, say for instance around Thanksgiving, you won’t have a full 180 days between then and you’re your tax return is due on April 15th correct? Okay, so if that is the case for your transaction, in order to get the full 180 days you will be needing to file an extension in order to include your exchange in your return. That’s what that tax return qualifier really means.
Okay, second important time rule. In addition, after you close your relinquished or exchange property, you’ll have 45 days from that closing in which to name candidate or targets properties in which to exchange. So that first 45 days out of the total of 180 is called the exchange period. Also, this is important to remember. You must identify under some basic rules. The only time you don’t really have to identify is if all your replacement property is already closed within that 45 day window. That’s kind of defacto identification anyway isn’t it? There are two rules for identifying and one exception which we cover elsewhere, but let me give you the rule which is used 95% of the time. It is this. The three property rule. And it is this: You can name or identify any three properties of any value. But your identification must be in writing, and it must be transmitted or postmarked within that 45 day period. Now you can use our online identification tool in the Exchanger Portal if you prefer. It simply handles the transmission aspect electronically and the signatures are digital. But it is pretty convenient if you are on vacation, and today is your 45 day and all you have is a smart phone. But those are the basic rules.

Why Should I Consider A 1031 Exchange?

Any property owner or investor who expects to acquire replacement property subsequent to the sale of his existing property should consider an exchange. To do otherwise would necessitate the payment of capital gain taxes in amounts which can exceed 20%-30%, depending on the appropriate combined federal and state tax rates. In other words, when purchasing replacement property without the benefit of an exchange, your buying power is dramatically reduced and represents only 70%-80% of what it did previously.

What Are The Different Types Of Exchanges?

Although the vast majority of exchanges occurring presently are delayed exchanges, let us briefly explain a few other exchanging alternatives.
Simultaneous Exchanges: Investors have been doing simultaneous exchange s since the 1920’s. In fact, prior to Congress modifying the Internal Revenue Code as to exchanges and formally approving the concept of delayed exchanging, virtually all exchanges were of the simultaneous type. To qualify as a simultaneous exchange, both the relinquished property and the replacement property must close and record on the same day.
Improvement and Construction Exchanges: In some cases, the replacement property requires new construction or significant improvements to be completed in order to make it viable for the specific purpose that an Exchanger has intended for it. This construction or improvements can be accomplished as part of a structured exchange process, with payments to contractors and other suppliers being made by the facilitator out of funds held in a trust account. Therefore, for instance if the replacement property is of lesser value than the relinquished property at the time of the original transaction, the improvement or construction costs can bring the value of the replacement property up to an exchange level or value which would be equal to the relinquished thereby allowing the transaction to remain tax free. Improvement and construction exchanges can be tricky however. That’s because the process does require the use of a concept which we use in reverse exchanges. Namely, a warehousing of the title until such a time as the improvements are done or the 180 days is close. This is because technically you cannot exchange into property you already own. So if you bought the replacement and then did the improvements, the value you added would not count towards the exchange. That is why we use what is called an EAT or exchange accommodation titleholder.
Reverse Exchanges: The reverse exchange is actually a misnomer. It represents an exchange in which the Exchanger locates a replacement property and wants to acquire it before the actual closing of the relinquished or exchange property. Since the Exchanger cannot purchase the replacement and later exchange into property that he already owns, he must find a method to acquire the replacement property and still maintain the integrity of his exchange. Reverses are typically accomplished in two formats based upon transaction logistics and the financing needs of the Exchanger. The Exchange Last strategy is utilized only when the Exchanger requires traditional financing to complete his acquisition of the replacement property. Since few lenders would lend dollars to the Exchanger with the facilitator or Qualified Intermediary (known in this case as an Exchange Accommodation Titleholder) on title, it is necessary for the facilitator to warehouse or hold the title to the relinquished property. In this approach, the exchange is complete at the moment the Exchanger accepts the title to the new replacement property. However, with the prospect of the exchange being complete, it is necessary to balance equities between relinquished and replacement, prior to closing. In other words, upon closing the replacement, there must be an equal amount of equity in the replacement property as is expected to come out of the later sale of the relinquished property. Then, at the time of the later sale of the relinquished or exchange property, any debt is retired and the Exchanger is repaid any dollars which he advanced for the replacement property acquisition. In an Exchange First scenario, the facilitator, with the aid of a loan from the Exchanger, acquires the replacement property and warehouses or holds the property title until such time as the relinquished property is sold and the exchange can be completed.
At this point we need to insert several caveats regarding reverse exchanges. They tend to be more complicated than other exchanges and because they involve the holding of title by a facilitator in the form of an Exchange Accommodation Titleholder, they require extensive planning. Do not undertake a reverse exchange without the assistance of an experienced and knowledgeable facilitator or intermediary.
Delayed or Deferred Exchanges: Generally, when one discusses exchanges, the type of exchange referred to is the delayed or Starker exchange. This term comes from the name of the Exchanger who was first challenged for a delayed exchange by the IRS. From this tax court conflict came the code change in 1984 that formally recognized the delayed exchange for the first time. As mentioned earlier, this is now the most common type of exchange. In a delayed exchange, the relinquished property is sold at Time 1, and after a delay, the replacement property is acquired at Time 2. The timing requirements are these: you have a total of 180 days or the due date of your tax return to complete an exchange. That is the exchange period. And, the first 45 days of the 180 is known as the identification period in which you need to identify some candidate or target properties to serve as your replacement. And that’s the types of exchanges.

Define Equity And Capital Gain?

Equity and Gain are both important to an exchange, but they are never the same number. Let’s take a cursory look at how you determine both equity and gain?
First equity represents the hard earned value that is yours in any property you own. So, if you take your gross selling price and subtract your closing expenses or closing costs, and then further subtract the amount of any debt, that remaining number which is left over will be your equity.
Now how about capital gain? Well in order to determine gain we need to know what is called your costs basis. And your cost basis is going to be informed by when you bought the property. So when you bought the property you had a purchase price correct? Well that will be the start of your cost basis, which actually changes over time. For instance, if you’ve done any improvements to the property that amount should be added. And likewise, if you’ve deducted any depreciation while you’ve owned the property that will be subtracted. Therefore, lets determine your cost basis and gain this way: Let’s find our final cost basis or adjusted basis. That will be our original purchase price, plus any improvement, and then less any depreciation, that gives us our final adjusted basis. Now let’s once again take that net selling price from our sale, deduct our final adjusted basis, and bingo, that’s our capital gain.
One last thing. Here is a very simple rule that works in exchanges if you want to have a totally tax free transaction. Number 1, buy a replacement property that is equal or greater in value than your net selling price, and 2, move all your equity from the old property into the new one. If you do those two things, plus replace your debt, you’ll be in excellent shape.

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01. Breakwater Capital is Specialized in DST 1031S

DSTs are what we do! We live and breathe DSTs. Other firms also offer financial planning, insurance, mutual funds, oil and gas, etc. making them generalists instead of specialists. At Breakwater Capital, we focus on DSTs, giving you the peace of mind that we understand and can help you with every element of a DST 1031 exchange. Consider it like going to a specialist for a knee or hip replacement instead of a general practice doctor.

02. Breakwater Capital has an experienced team of DST 1031 Professionals

We have team members licensed in all 50 states, Washington DC and the US Virgin Islands. We have offices in Los Angeles, San Diego, San Francisco, Seattle, Boston, New York City, and Washington, DC, over 150 years of collective real estate experience, and over $30 billion of DST participation. No matter if you live near one of our offices or not, we have representatives who would be happy to meet with you. We’re always just a phone call away.

03. Breakwater Capital is picky with its DST properties

Breakwater Capital has access to on-market DST properties from almost all of the sponsor companies and asset managers in the DST 1031 space. However, we reject certain properties that do not pass our robust due diligence due to high risk, high fees, and lack of previous performance. This is more than just broker dealer due diligence – although we have that too. We do our own due diligence, and our team has analyzed billions of dollars of investment real estate. Many of our competitors will still offer these properties to you that we’ve rejected – so be vigilant and always understand the risks.

04. Breakwater Capital has access to off-market DST properties

These exclusive DST properties are only available to our clients. These Breakwater Capital client-only DST offerings often have a dramatically lower fee structure than standard DSTs. Lower fees means more of your hard earned dollars in the ground and working for you as opposed to in the financial planner and DST sponsor companies pockets!

05. Breakwater Capital values integrity first

We will not sell the higher risk asset classes such as hotels, senior care, and oil and gas…even if they pay a higher fee to us. We will not use our clients as guinea pigs just to make a few extra bucks.

06. Breakwater Capital has a large inventory of DST properties.

We typically have at least 30 to 45 DST offerings at any given time. You can check out our DST property menu to see what offerings are available and have passed our DST due diligence analysis. Just call a representative, share your situation, and ask to see our menu, or register on our website to get a free list of our DST 1031 properties.

07. Breakwater Capital mystery shops each and every DST property offered

We believe we are one of the few firms that actually sends someone out to inspect every DST property we offer to clients – even portfolio DSTs with 10 to 25 properties. We make sure every DST property we offer has been inspected not just on paper (although our analysts love doing this) but in person as well.

08. Breakwater Capital has access to leveraged DSTs for debt replacement

We have access to DSTs that typically have a 40% to 65% loan-to-offering value. These DST properties have non-recourse loans in place and are able to be closed on typically within 3-5 business days for those investors needing to replace debt in their 1031 exchanges as well as those that want to increase their potential tax efficiencies by buying more real estate and increasing their basis.

09. Breakwater Capital has access to All-Cash/Debt-Free DSTs

If you’re an investor who doesn’t want the risk of lender foreclosure, this one is especially important to you. At Breakwater Capital, we offer many all-cash/debt-free DST properties. Not many groups have access to a wide variety of debt free DST properties like Breakwater Capital does. Call one of our representatives to discuss your situation and what debt free DST investments we have available.

10. Breakwater Capital walks the walk

Our team members are proud to be personally invested in multiple DSTs as part of our investment strategy. We don’t just assist others, we personally invest in DSTs ourselves and can give you advice based on personal experience.

The post 10 Reasons Why Clients Choose Breakwater to Purchase DST 1031 Investments appeared first on Breakwater Capital 1031.

Moreover, unlike investing in a syndication or fund, DSTs have been deemed “1031 Exchange eligible,” meaning that individuals can sell their personally owned investment property and re-invest the proceeds into a DST to defer paying capital gains tax. It’s no wonder then that DSTs are rapidly growing in popularity.

The History of DSTs

Trusts have long been a tool used by wealthy Americans to transfer property from one generation to another. Doing so through a trust has specific tax and security advantages that would not otherwise exist.
DSTs did not just emerge overnight. Their arrival was long in the making. In this article, we look at the history of DSTs and how they came about. Many of these trusts are held in Delaware, a state that is known to be pro-business and tax friendly. Since at least 1947, business trusts have been recognized by Delaware common law. This is why many Fortune 500 companies have located their headquarters in the state. For decades, trust income, including capital gains, have not been taxed – including those owned by non-residents. In other words, someone who lives out of state can just as easily take advantage of Delaware’s trust tax provisions as those who reside there. In 1988, Delaware formalized its common law around trusts and became the first state to create an effective and judicially-secure legal entity: the Delaware Statutory Trust (DST). The 1988 Delaware Business Trust Act provided clear guidance as to how trusts may operate. This provided investors with the certainty they needed to feel confident investing in DSTs.

Several other states have since adopted legislation that governs trusts, but Delaware remains a preferred location among trustees given the breadth and clarity of the laws governing business entities. Moreover, Delaware’s Court of Chancery and the Delaware Supreme Court have earned a reputation for excellence—specifically, their wide-ranging experience with business issues that result in efficient, prompt, and fair resolution of disputes. Today, there is a tremendous body of Delaware case law that can be drawn upon for those seeking trust-related guidance.

In 2002, the Delaware Business Trust Act was changed to the Delaware Statutory Trust Act (DST Act) (Title 12, Ch. 38 of the Delaware Code). The DST Act explicitly authorized the creation of DSTs and provides express rules governing their internal affairs. The DST Act identifies DSTs as a separate legal entity that may conduct any lawful business or purpose. The regulations also stipulate that a DST will not terminate or dissolve as a result of the death, incapacity, dissolution, termination or bankruptcy of a beneficial owner unless otherwise stated in the Trust Agreement. DSTs are also allowed to secure financing under their own name rather than under the names of its individual trustees.

The DST Act also expressly limits the liability of any trustee. The Act states that, except to the extent otherwise expressly provided in the trust’s governing documents, a trustee “shall not be personally liable to any other person other than the statutory trust or a beneficial owner for any act, omission or obligation of the statutory trust or any trustee thereof.” This provision offers substantial protection to trustees—they can rest easy knowing that the potential liabilities they may face associated with investing in a DST are strictly limited, whereas the protections afforded to them by indemnification are very broad.

DSTs vs TICs

The 2002 DST Act effectively provided the guidance and protections needed for those looking to fractionally invest in commercial real estate. Until this point, most people would co-invest in real estate through a tenant-in-common (or “TIC”) structure.

Those who invest in a TIC hold a fractional share of the title to the property. As such, each individual owner becomes personally liable for any debt needed to purchase or improve property held in a TIC. TICs may have up to 35 individual co-owners, so as one might imagine, the process for underwriting each individual investor can make financing a TIC rather cumbersome compared to financing DST investments, since the loan is secured by the DST itself and not individual investors.

Moreover, any major decision pertaining to TIC investments requires unanimous approval among co-investors. Decision-making, even in the best of times, therefore becomes a challenge. One hold-out can stall important decisions needed to advance the TIC’s business plan and investment direction.

Despite the clear advantages to investing in a DST versus a TIC, many continued to opt for the latter until the mid-2000s. This is because in the early 2000s, industry groups, including some of the nation’s largest commercial real estate sponsors, pushed the IRS to establish guidelines that would allow TIC real estate to qualify for 1031 exchanges (IRS Revenue Procedure 2002-22). In turn, those who sold individually-owned investment property could reinvest the proceeds from the sale into a TIC to defer paying capital gains tax (sometimes, indefinitely).

This led to more people investing in TICs than ever before. The TIC industry grew to its height in 2007 when almost $4 billion of equity was invested using the TIC structure. But before long, many of these investors gained first-hand insight as to the TIC structure’s shortcomings.Around this same time, and largely due to the inefficiencies of the TIC model, DSTs gained traction. In 2004, the IRS adopted similar 1031 exchange guidelines for DSTs. Revenue Ruling 2004-86 allowed the use of the DST structure to acquire real estate where the beneficial interests of the trust would be treated as direct interests in replacement property for the purposes of a 1031 exchange. Real estate investors across the U.S. rejoiced.

Real Estate Co-Investment During the Great Recession

Both TICs and DSTs were dealt an enormous blow when the Great Recession hit in 2008. Investment in syndicated real estate fell off a cliff. TICs suffered more than DSTs. By 2009, less than $250 million was invested in TICs – roughly 6.25% of the equity invested just two years prior. Across the board, lenders became conservative. Very few, in particular, wanted to invest in TICs given the need to underwrite each investor’s creditworthiness. The work to establish loans on TICs (which again, could have up to 35 individual investors) simply became too much of a bother for banks.

Investment in both TICs and DSTs remained in a lull through the better part of 2013. As the economy began to recover, DSTs quickly became the preferred co-investment structure. By 2015, DST investment had rebounded to its pre-recession level and has continued to climb ever since.

In 2020, roughly $3.20 billion in equity was raised for DST investments – a staggering number, especially given the lingering uncertainty among investors brought on by COVID

The Future Outlook for DSTs

Looking forward, investment in DSTs could continue to remain strong. There is a backlog of investors who have been eagerly waiting for the pandemic to pass before listing their property for sale. Many of these investors may utilize 1031 exchanges to defer paying capital gains tax, and many will do so by investing in DSTs. Cash investors, too, are increasingly investing in DSTs as a way of diversifying their portfolios. Accredited investors seeking to invest in truly passive real estate may find DSTs as a tremendous option given the myriad of associated potential benefits, including asset and geographic diversification.

2021 was a banner year for DST equity investment. Barring any unforeseen circumstances, this may continue in the months and years to come.

Are you interested in learning more about DSTs? Contact us today to learn more about our investment strategy and current 1031 exchange and DST offerings.

The post History of Delaware Statutory Trusts (DSTs) appeared first on Breakwater Capital 1031.

Eliminating the day-to-day headaches of property management

Many of our clients are at or near retirement, and they are tired of the hassles that real estate ownership and management often bring. They are tired of the tenants, toilets and trash and are wanting to move away from actively managing properties. The DST 1031 property provides a passive ownership structure, allowing them to enjoy retirement, grandkids, travel and leisure, as well as to focus on other things that they are more passionate about instead of property management headaches.

Tax deferral using the 1031 exchange

Many of our clients have wanted to sell their apartments, rentals and commercial properties for years but haven’t been able to find a property to exchange into and just can’t stomach the tax bill after adding up federal capital gains tax, state capital gains tax, depreciation recapture tax and the Medicare surtax. The DST 1031 property solution provides investors an ability to move from an active to a passive role of real estate ownership on a tax-deferred basis.

Increased cash flow potential

Many investors are receiving a lower amount of cash flow on their current properties than they could be, due to their properties having under-market rents, properties that have multiple vacancies and/or that are raw or vacant land sitting idle. DST 1031 exchange properties provide an opportunity for investors to potentially increase their cash flow on their real estate holdings via a tax deferred 1031 exchange.

Portfolio diversification by geography and property types

Often times, 1031 investors are selling a property that comprises a substantial amount of their net worth. They want to reduce their potential risk and instead of buying one property (such as another apartment building) or one NNN building (such as a Walgreens pharmacy or Taco Bell restaurant) they decide that investing into a diversified portfolio of DST 1031 properties with multiple locations, asset classes (property types) and tenants is a better fit for their goals and objectives. This is similar to how investors tend to invest retirement funds in mutual funds and Exchange Traded Funds (ETFs), as opposed to placing their entire retirement savings into the stock of one particular company. However, it is important to note that there are no assurances that diversification will produce profits or guarantee against loss.

Long-term non-recourse financing locked and in place to satisfy debt replacement requirements of the 1031 exchange
One of the requirements for a 1031 exchange is to take on “equal or greater debt” in the replacement property to what you had in the relinquished property (the property you are selling). In today’s lending environment, it is often hard for investors to obtain non-recourse financing at an acceptable interest rate and terms. Due to the DST 1031 properties’ sponsors typically having strong lending relationships, they are able to secure non-recourse financing at some of the best terms available in the marketplace. The DST 1031 investors are the direct recipient of these financing terms that they would otherwise often not be able to obtain on their own.

Access to Institutional Grade Real Estate

DST 1031 properties provide access to large, institutional-grade real estate that is often otherwise outside of an individual investor’s price point. With the typical minimum investment of $100,000, investors are still able to purchase an ownership interest in large $20 million-plus apartment communities, $5 million-plus pharmacies or $15 million grocery stores, for example. This allows investors access to a level of real estate that they just would not have been able to exchange into before.
That being said, we also have had many clients with very large 1031 exchanges opt to invest in DST 1031 properties because they did not want to place “all their eggs into one basket” by purchasing one single, large investment property.

Unlocking trapped equity

For those investors that have a substantial amount of equity in raw or unimproved land (as well as investors with vacant properties that are not producing any cash flow), the DST 1031 property allows them the opportunity to sell, defer taxes via a 1031 exchange and unlock the trapped equity that they have in their properties. Now this trapped equity is free to produce for the investor potential cash flow on a monthly basis.

Ability to typically close on a DST 1031 property typically within three to five business days of completing and returning subscription documents

This is one of the main reasons why investors in their 45-day identification period “time crunch” often turn to DST properties. They are able to close quickly and complete their exchanges due to the properties being pre- packaged, as opposed to waiting 30, 60 or 90 days to purchase another outside property.

Increased tax efficiency due to depreciation deductions on replacement property

Investors that have owned their apartments and rental properties for longer than 27.5 years and commercial properties for longer than 39 years have fully depreciated the properties, with no more deductions to help shelter the rental income. By purchasing DST 1031 properties that have a greater amount of financing than their relinquished (sold) properties, those investors are creating for themselves a new basis to shelter rental income through. We encourage all investors to speak with their CPA and tax attorney regarding this prior to investing in DST 1031 properties for details regarding their particular situation.

Increased tax efficiency due to interest write-offs

For investors that have fully paid off their properties, the DST 1031 properties with financing in place provide for interest write-offs to help shelter potential cash flows. Many clients in today’s environment are looking for a way to increase tax efficiency due to the burdensome tax system in place in the United States. The DST 1031 can help to potentially solve some of these tax problems.

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As the markets continue their recovery in 2013 and beyond, investors face a more challenging tax environment. Federal capital gains taxes have increased from 15 percent to 20 percent for high-income taxpayers, passive investment income is now subject to a 3.8 percent Medicare tax, and many states are attacking budget shortfalls through higher taxes. Separately, scores of old Section 1031 investment programs — designed to defer taxes pursuant to Section 1031 of the federal tax law — are coming full cycle in the next three to five years. This correlation of events is reinvigorating interest in new tax-deferred investment programs.

Section 1031 programs were popular in the mid-2000s, principally for high-net-worth individuals and family trusts and offices, commanding several billion dollars in invested capital. They declined dramatically between 2008 and 2011, dipping to around $100 million in invested capital in 2009. However, Section 1031 programs are beginning to rebound again, growing to roughly $250 million of invested capital in 2012, with potential growth of $1 billion to $3 billion of invested capital per year over the next three years.

DST ADVANTAGES

Prior to 2008, the predominant investment vehicle for Section 1031 programs was the tenancy-in-common, or TIC, program. Now virtually all new Section 1031 programs are being structured as Delaware Statutory Trust, or DST, programs, principally for the following reasons.Management and control. In TIC deals, the Internal Revenue Service requires that certain fundamental decisions, such as selling or refinancing the property or entering into lease, management, or brokerage agreements, be made unanimously by investors. During the market collapse of 2008–11, numerous TIC deals were derailed because one or more rogue investors could hold up a deal. In contrast, a DST structure takes all decision-making out of the hands of investors and places it with a sponsor-affiliated trustee. Accordingly, in times of crisis, DSTs are more agile decision-makers than TIC programs.

Structural simplicity. TIC deals require each investor to form a special purpose entity, usually an LLC, to own the TIC interest and to join a co-ownership agreement (governing relations with other investors), a management agreement or master lease (governing relations with the investment program sponsor), a loan agreement, and a real estate deed. In addition, each investor must execute an environmental indemnity and a “bad boy carve-out” loan guaranty, which provides for personal recourse against the investor if he or she takes certain actions that are in bad faith or that cause a loan default. This plethora of arrangements is difficult to digest, costly to maintain, and involves a high level of investor risk.

By contrast, a DST investor executes only one document — a trust agreement. There are no deeds or loan documents for investors to sign and no environmental or carve-out guaranties for them to execute. Enhanced scalability and diversification. Because the IRS limits the number of investors in a single TIC program to 35, they are generally limited to properties less than $25 million in total value and require large minimum investments, often at least $500,000. DSTs, however, are not subject to an investor limit under the tax law, and under the 2012 JOBS Act, can have up to 2,000 investors. Thus, DSTs can own properties with aggregate value much greater than any TIC deal, while simultaneously accommodating much smaller minimum investments, allowing diversification of investments across multiple DST programs.

DST CHALLENGES

In certain respects, DST programs are more restrictive than TIC programs. For a DST to qualify for Section 1031 purposes, it must not violate the IRS’ “seven deadly sins.” That means that a DST: (1) cannot receive new capital after an offering is closed; (2) cannot renegotiate or enter into new mortgage debt unless there is a tenant bankruptcy or insolvency; (3) cannot renegotiate any of its property leases or enter into any new leases unless there is a tenant bankruptcy or insolvency; (4) cannot reinvest the proceeds from the sale of its property; (5) cannot redevelop property and, in fact, is limited to performing only normal maintenance and minor nonstructural improvements unless it is required to do more by law; (6) must hold its reserves in short-term debt obligations; and (7) must distribute all cash, other than normal reserves, on a current basis.

These restrictions caused many investors and broker-dealers to prefer the TIC structure during the mid-2000s. Ironically, many property problems arise from tenant bankruptcies or insolvencies, which a DST can resolve quickly, but a TIC structure can only resolve through a long and uncertain decision process. When issues arise that a DST cannot address due to the seven deadly sins, it converts into an LLC. While this conversion inhibits investors’ ability to do future Section 1031 transactions, it allows property emergencies to be dealt with appropriately.

Given the restrictions on their activities, DSTs are not designed for all property classes. They are best suited for properties subject to a long-term lease to a creditworthy tenant on a triple-net basis. They can also successfully be used with a master-lease structure to hold multifamily, student and senior housing, hospitality, and self-storage facilities.

With markets in full recovery, tax rates on investment income nearly 50 percent higher than they were in the 2000s, and scores of old Section 1031 investment programs coming full cycle, many real estate investors will turn to DST programs to shelter their real estate investment gains.

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