The IRS Issues CV-19 Tax Relief for Delaware Statutory Trusts, a Common Investment Option for 1031 Exchange Investors

By: James T. Walther, Esq., LL.M.

Interests in Delaware Statutory Trusts (“DSTs”) are commonly purchased as replacement properties by 1031 investors. The IRS allows these fractional interests in an investment trust holding real estate to qualify as 1031 replacement property if they meet certain criteria and comply with conditions set forth in Rev. Rul. 2004-86. DST investments are an attractive option because they can provide multiple 1031 investors the opportunity to pool their exchange funds to invest in institutional quality investments and defer capital gains taxes. In addition, there is the potential for the investor to exchange out of the DST interest in the future. The result is access to high quality deals that they otherwise would not be able to afford individually, with some separation and flexibility from the other investors, and no management responsibility. Furthermore, assumable non-recourse financing makes these investments easy to close within the exchange period and they can also be used to help balance the debt equity requirement of the exchange.  To be clear, an investor does not have to utilize a 1031 exchange to invest in a DST.  A DST interest is an investment option and not a “tax strategy” on its own or an “alternative to an exchange” as they are often inaccurately described.

These investments do come with several downsides and as with any real estate deal, each investment opportunity should be properly vetted. In a nutshell, the DST entity itself is very inflexible and must be structured to remain as a very passive investment to qualify as 1031 exchange property. Among the inflexible aspects, non-compliance with certain conditions in Rev. Rul. 2004-86 commonly referred to as “the seven deadly sins” can result in a disallowance of eligibility as “like kind” real estate and trigger tax consequences. For example, three of the sins provide these limitations – once the trust is closed: 1) the trustee cannot modify the mortgage; 2) the trustee cannot renegotiate leases with tenants; and 3) trust cannot accept additional cash contributions.

Due to the pandemic, the IRS issued Rev. Proc. 2020-34 which temporarily relaxed the above limitations until December 31, 2020. This relief allows DST trustees to adjust due to the pandemic. For instance, under the safe harbors in Rev. Proc. 2020-34, a trustee now has temporary leeway to renegotiate a lease with a tenant that suffered hardships due to the pandemic. They can also request or enter a forbearance program with their lender as specified in the Rev. Proc. This relief helps provide investors with more confidence in DST investments because DSTs usually invest in net-lease properties that are typically retail, restaurants, or other sectors that were hit hard by the pandemic. For example, many restaurant chains and retail stores that have had to temporarily close or scale back operations during the pandemic. Absent this relief, the pandemic would pose significant problems for DSTs and their investors. In addition, an ongoing consideration is the long-term impact of the pandemic, how it will change the way we live and work, because DSTs also commonly own other affected properties like offices and gyms. To support the argument that additional/longer relief may be needed, simply contrast these tenant types and the DST limitations with traditional net-lease landlords who have the flexibility to adjust to tenant issues at any time. Investors evaluating DSTs should be certain to involve experienced tax and investment advisors in their decisions and be cautious not to let the 1031 tax benefits control their investment decisions.

Rev. Proc. 2020-34 was a win for DST investors, DST sponsors, and their tenants, who deserved some flexibility from the Seven Deadly Sins even if temporarily (there are now four sins). However, the IRS may need to revisit the idea of providing DST investors and sponsors with additional relief due to the pandemic’s long-term effects on some tenant types.

Legal 1031 does not provide tax or legal advice, nor can we make any representations or warranties regarding the tax consequences of any transaction. Taxpayers must consult their tax and/or legal advisors for this information. Unless otherwise expressly indicated, any perceived federal tax advice contained in this article/communication, including attachments and enclosures, is not intended or written to be used, and may not be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein.

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