Statutory Trust
What is a Statutory Trust?
A Trust created by an operation of law where trustees hold the real property for the immediate or essential sale using their discretion. All income from the property before its sale, and all the proceeds of its sale are held in trust for the advance of the trust’s beneficiaries.
What are Delaware Statutory Trusts?
Delaware is one of the few states in America that has a statutory trust law. Most states in America still rely upon common law trusts. The Delaware Statutory Trust (DST) is a statutory entity formed by filing a Certificate of Trust with the Delaware Division of Corporations. It is governed by Chapter 38, Part V, Title 12 of the annotated Delaware Code. However, Delaware Statutory Trust (DST) is not brand-new, but with current tax laws, it has become the preferred investment vehicle for passive 1031 exchange investors and direct (non-1031) investors alike.
Basically, DSTs are inferred from Delaware Statutory law as a separate legal entity, which qualifies under Section 1031 as a tax-deferred exchange and is created as a trust. In 2004, the IRS gave DSTs an official Revenue Ruling about how to structure a DST that will qualify as replacement property for 1031 Exchanges.
Each of the DSTs need to be:
- A Special Purpose Entity (SPE);
- Bankruptcy remote;
- A very passive holder of real estate having minimum trustee powers over the operation of the DST’s real estate along with no powers over the DST or its real estate at all in the hands of the DST’s beneficiaries.
IRS Requirement Inducing Lender Concerns
The basis of DST transactions formed by IRS Revenue Ruling 2004-86, sets ahead interdictions on the trustee’s powers, which are known as the “seven deadly sins.” These are:
- If the offering is closed, DST cannot accept any future capital contributions from current or new beneficiaries.
- The trustee is not permitted to renegotiate the terms of existing mortgage loans. Also, the trustee cannot get any new mortgage financing from any party except
- The trustee is not allowed to renegotiate the existing leases or enter into any new leases except where a property tenant is insolvent or bankrupt.
- The trustee is not permitted to reinvest the profits from the sale of its real estate.
- The cash held between the distribution dates can only be invested in short-term debt obligations.
- All cash except the required reserves needs to be distributed on a regular basis.
- The trustee is confined to make the following types of capital expenses concerning the property:
- (a) expenses for regular repair and maintenance of the property,
- (b) expenditures for minor non-structural capital renovations of the property, and
- (c) expenditures on improvements or repairs required by law.
Due to these restrictions, the only types of real estate transactions that work in a DST are Master Lease Transaction. In this transaction, the master tenant takes all the leasing and other property operation responsibilities. Also, a triple-net-long-term lease to the quality tenant.
Characteristics And Advantages of Statutory Trust
Ease of Formation and Maintenance at Minimum Cost
DSTs are easy and inexpensive to form and maintain. It’s formed by filing a “short form” certificate and by entering into a Trust Agreement. A reasonable fee is paid to the Delaware Secretary of State upon the filing of a certificate of trust or the certificate of formation. No annual fees or franchise taxes are required to be paid to the State of Delaware by a DST. Also, a DST expects that there should be a trustee within the State of Delaware.
Contractual Freedom
The primary approach of the DST Act is to let the parties define their business relationship and to provide rules only in the circumstances where the parties do not agree with a decision.
The stated policy of the statute is to give the most effective principle of freedom of contract and the enforceability of a DST’s Trust Agreement. This permits the parties to create the relationships that suit their business needs perfectly and to determine nearly all aspects of those relationships by an agreement.
For example, in the DST’s Trust Agreement, parties may provide for various classes of beneficial owners, with each class enjoying different powers, rights, and duties, including economic rights and separate voting rights. Also, the DST Act provides that to the extent that a trustee of a DST has duties (along with fiduciary duties) to the entity and specific constituents, the DST’s Trust Agreement can also expand, limit or exclude such duties. (The removal of such duties is an essential tool in addressing the concerns conferred by the General Growth bankruptcy matter.)
Limited Liability
The beneficial owners and trustees of a DST, have no personal liability for the obligations and debts of the entity. In addition, the DST Act empower DSTs to “indemnify and hold harmless any person from and against any and all claims and demands whatsoever.” This restriction on personal liability and wide scope of permissible compensations are viewed favorably by prospective investors and industry professionals.
Management Flexibility
A trustee or trustees typically manage the affairs and business of a DST. A Trust Agreement includes all the information about the management by other persons, usually the DST’s beneficial owners or third-parties. The Trust Agreement may approach any aspect of the DST’s management practically.
For instance, it may grant for an amendment of the Trust Agreement, a merger, consolidation or conversion, or a sale of trust property with or without the approval or vote of any particular trustee, a beneficial owner or a third-party, as the parties may want.
A DST offers overall management flexibility, allowing parties to choose the arrangement that works best for them. Under the DST Act, the trustees can participate in management without jeopardizing their limited liability. The Agreement may provide laws for different classes of members and managers, each having the desired rights, powers, and duties.
Tax Advantages
As a matter of US federal income tax law, a DST can be structured in a way that it will not be subject to tax at the business organization level. Therefore, from a tax perspective, DSTs offer a tax-efficient alternative to the corporation, which typically is taxed at the organization level. Indeed, the contractual freedom afforded by the DST Act enables parties to select the tax treatment most suitable to their business needs.
Disadvantages of Statutory Trust
A 1031 DST Cannot Raise New Capital
As per IRS requirements, once the DST atonement is closed, there can be no future contributions to the DST by either the current or the new investor. Major capital items like replacing a roof or parking lot can easily consume many years of profits. Likewise, the change in occupancy or rents results in abundant reductions in property cash flow. Since a DST cannot propose new capital with one of these expected or unexpected events, keeping aside sufficient reserves appropriately is required.
1031 DST Investors Have No Control
When the IRS approved the DST structure for exchanges, it clearly specified that the 1031 investors cannot have any operational control or authority to make decisions for the fundamental properties Although many sponsors welcome and even inspire investor in a DST to provide input or feedback, this should not be mixed with control. The DST investors cannot take any minor or major action, whether it’s planting flowers or selling a property.
1031 DST Properties Are Illiquid
If you’re considering a DST, you must know that your equity will remain invested until the properties are sold. DSTs are deep-rooted investments, with expected investment periods usually between 5 to 10 years. There’s no dependent or public market where you can sell your ownership interests as a DST. Also, each DST offering comprises of the additional restrictions on resale.
Risks of Delaware Statutory Trusts
The risks of investing in a DST involve but are not limited to:
- the risk of sponsor bankruptcy;
- the risk of depending on the program sponsor and their extended success and competency;
- the risks associated with giving complete responsibility regarding the management, leasing or distribution of the property to a third party;
- the risk of being inadequate to refinance the program at the end of the term of the stated loan, if the property held by the DST is leveraged;
- the risk of apparent conflicts of interest with business sponsors, trustees, or property managers.
Also, there are tax-related risks when using a DST ownership structure for a 1031 exchange.
Conclusion
All things considered, these are the merits and demerits that come with the Delaware Statutory Trust. In case you have any problems understanding the duties of the trust, we would recommend that you seek advice from an experienced professional. Just confirm that they’re licensed and check-out what makes them different from other available services.