Trawnegan Gall on Understanding the Parties Involved in a Delaware Statutory Trust Investment

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Delaware Statutory Trust (DST) investments have been significantly increasing in volume over the last several years mainly because a DST investments can provide a truly passive institutional quality replacement property for 1031 exchange. A DST investment allows the exchanger to retire from active management of real estate and yet still avail of the deferral of capital gains tax which would otherwise be due upon the sale of their original owner-managed real estate. 

One of the most difficult and complicated elements of a DST investment is understanding the various parties involved which includes; the investor/exchanger themselves, the sponsor of the DST, the DST itself, the broker dealer or registered investment advisor, the securities broker or investment advisor, and the qualified intermediary.  Also of significance are the master tenant, the property manager, the trustee of the trust, and other entities. 

The investor/exchanger can be a real person, a married couple or any type of entity (LLC, LP, revocable trust, irrevocable trust, S-Corporation, C-Corporation, etc.). It is this person/couple/entity which is conducting the 1031 exchange and which will be the “owner”, the beneficial interest holder, of the DST. The investor is considered both a grantor to the trust in the sense of contributing capital to the trust, and a beneficiary of the trust with their rights as a beneficiary described in the trust agreement. The two primary rights of a beneficiary of a DST are the right to receive their pro-rata share of the rental proceeds as defined by the master lease and the trust agreement, and the right to receive their pro-rata share of the sale proceeds net of closing costs and a sponsor disposition fee. 

The sponsor of the DST originates the DST offering by setting up the DST itself. The sponsor surveys the real estate market, conducts due diligence upon the property(ies) under consideration and arranges for the acquisition of the property(ies) by the DST which has been set up for this sole purpose. Then the sponsor syndicates the DST as a security offering which means preparing the private placement memorandum (PPM), marketing the DST to various broker dealers and registered investment advisors, all of whom will conduct their own due diligence upon the offering, and singing selling agreements with these broker dealers and RIAs.  The sponsor, or a special purpose entities (SPEs) affiliated with the sponsor, will also function as the master tenant according to the master lease of the DST, the property manager, and the signatory trustee of the trust.  

The sponsor will either manage the property directly through an in-house affiliated management company, or will contract property management to a third party. Either way property management is ultimately the responsibility of the sponsor. 

An affiliate of the sponsor will also function as the master tenant under the master lease. Without going into too much detail, a long term master lease is often required to meet IRS 1031 rules outlined in Revenue Ruling 2004-86. For this reason the sponsor will set up a lightly capitalized SPE to serve as the master tenant. The master tenant will then sub-lease the property to the actual tenant(s). 

The sponsor also manages the DST investment itself, arranges distributions, takes care of investor relations, provides quarterly reporting and annual tax documents, and will take care of the sale of the DST property and its final disposition including providing final closing statements and an analysis of the total return of the DST investment. This function typically called “asset management” which is distinct from property management.

The DST itself, a trust established according to Delaware Statutory law, is an independent legal and economic entity. The sponsor SPE functions as the trustee of the trust but it is the investors themselves who are the “owners”, the beneficiaries of the trust. The rights and obligations of the investor-beneficiaries are described in the trust agreement. Thus the investors do not invest in the sponsor directly. They are investing directly in the DST which is its own entity managed by the sponsor. 

The role of the sponsor in selecting the property(ies), overseeing the management of the property(ies), functioning as the trustee of the trust, and overseeing the security investment overall cannot be overemphasized. However, it is also important to understand that the sponsor is not the DST itself. The DST is a trust set up under Delaware statutory law with the investors themselves as the beneficiaries of the trust. In this sense it is the investors themselves who are the DST, not the sponsor. Along this line, if a sponsor were to go bankrupt, the creditors of the sponsor cannot access the assets (the property) of that sponsor’s DSTs because the sponsor does not own the DSTs. It is the investors which “own” the DST.  In extreme cases, the investors/beneficiaries of the trust can even remove the sponsor as the trustee of the trust and appoint a new trustee. 

For commission-based brokerage transactions there will be a broker dealer and a securities broker, both of which are required to conduct their own due diligence upon the DST offering before making it available to prospective investors. Importantly, in the context of this article, the securities broker will also conduct diligence upon the DST sponsor. Investors will work directly with the securities broker who should make various options available and describe the characteristics and risks of each DST and each sponsor to the investor. The broker dealer will process the security transaction, the actual investment, making sure that all the requisite documents have been completed, conduct investor due diligence, etc. 

For those exchangers who have their assets under the management of a registered investment advisor (RIA), they will work with an investment advisor with the same goal of selecting suitable DST replacement properties for their 1031 exchange. 

Finally, there is the qualified intermediary which is a critical role in any 1031 exchange, not only 1031 exchanges into DSTs. According to IRS 1031 regulations, the QI must receive the proceeds from the sale of the relinquished property and effect the purchase of the replacement property. This function is the same whether the replacement property is a DST or a traditional piece of real estate. Upon the sale of a DST on the back end, both the relinquished property and the replacement properties may be DSTs with the QI carrying out their function the same as any other 1031 exchange. 

To review in brief, a sponsor will set up the DST, acquire the property and syndicate the DST as a security. The investor, with the help of a broker/broker dealer or investment advisor/RIA exchanges into/invests in the DST. The sponsor manages the DST and is responsible for property and asset management. The investor/exchanger, as a grantor and a beneficiary of the trust, is the “owner” of the DST itself. 

It is very important for investors/exchangers to consider the risks entailed in a DST investment. DSTs are private placement securities limited to accredited investors. They are illiquid investments with a projected long-term hold period. They are passive which means that the investor has no participation in the management or decisions of the DST. There are numerous additional risks, real estate risks, market risks, securities risks, etc., all of which are detailed in the offering materials, and all of which must be carefully considered by the investor/exchanger.

About Trawnegan Gall

Trawnegan Gall is the Senior Vice President of Cornerstone Real Estate Investment Services and is located in Dallas, Texas. Cornerstone serves a national clientele, helping clients invest in institutional quality securitized real estate offerings, including DSTs for 1031 exchange.

Mr. Gall has brokered more than $350 million into real estate securities over the last 10 years. He is the co-author of Modern Real Estate Investing, the Delaware Statutory Trust, and is one of the field’s strongest proponents of industry best practices.

Also Read: Retirement Planning: 16 Tips To Choose The Best Retirement Investments



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