The 7 Deadly Sins of Delaware Statutory Trusts (DSTs) for 1031 Exchange: Rules, Compliance and Risk

A Delaware Statutory Trust (DST) for 1031 exchange can qualify as a like-kind property for Section 1031 tax deferral, but only if the DST avoids violating IRS compliance rules.

What is a DST?

A Delaware Statutory Trust (DST) is a legal entity created under Delaware law that allows multiple investors to co-own fractional interests in a single, professionally managed real estate portfolio. DSTs are commonly used as passive investment vehicles, especially for those seeking the benefits of 1031 exchange tax deferral and simplified property ownership.

Why Delaware Statutory Trusts (DSTs) for 1031 exchange are attractive to investors

Delaware Statutory Trusts (DSTs) allow for groups of investors to pool their capital into a vehicle that invests in large-scale commercial real estate. Investors like DSTs because they:

• provide diversification
• create passive income
• give everyday investors access to high-quality properties.

DSTs have become increasingly popular with property owners performing IRC Section 1031 like-kind exchanges because a DST interest is considered a like-kind business or investment property under Section 1031. DSTs utilize non-recourse loans and can replace debt at the correct level to allow investors to fully defer taxes.

While a 1031 exchange into a DST can be enticing, it’s important to pick the right DST, as not every trust is designed to facilitate IRS-compliant like-kind 1031 exchanges. There are certain things investors must look out for to ensure they can make another exchange out of the DST after its holding period.

DSTs and 1031 exchange compliance: what investors need to know

In addition to considerations like property type, risk profile, and distribution schedule, investors must focus on maintaining tax-deferral status. They need to be sure their investment will qualify for tax deferral both now and when the DST is sold.

Other investors who are not selling business or investment property to invest in the DST (and who don’t plan to perform an exchange out of the DST) don’t have to worry about all of these things, so not all rules matter to all investors in the same way. Therefore, 1031 exchange investors must make sure their chosen DST adheres to a stricter set of directives to preserve Section 1031 eligibility.

To limit confusion, the IRS issued Rev. Ruling 2004-86, which outlines how a DST “will be classified for federal tax purposes and whether a taxpayer may acquire an interest in the Delaware statutory trust without recognition of gain or loss under section 1031.”

If the DST sponsor wishes their offering to qualify under Section 1031, they must avoid breaking the rules outlined in the revenue ruling. These rules have come to be known as the Seven Deadly Sins of DSTs, and both sponsors and exchangers should familiarize themselves with them, because a failure to adhere to these rules can have major tax consequences.

The Seven Deadly Sins of DSTs for 1031 exchange compliance

Sin #1: Accepting new equity contributions after the DST is closed

Once the trust is closed, new contributions are not allowed, whether they are from current beneficiaries or new ones. Any capital used to acquire and manage the portfolio properties is limited to the original raise. The number of investors is set, and the DST can’t take on new investors.

• IRS rule: The trustee cannot “accept additional contributions of assets (including money).”
• The reason: The reason for this is that if the trust takes on new investors or raises additional capital from some existing investors, that would change the percentage of the trust that each investor owns.
• The downside: The downside to this rule is that because there can be no capital calls, funds can’t be raised in the event of a sudden economic downturn, natural disaster, or other unforeseeable event. All future expenditures must be factored into the original offering.
• Why this matters for 1031 investors: If your ownership percentage were to be diluted, that would affect your claim to the DST’s assets, and would potentially mean both smaller dividends and a smaller payout when the trust’s portfolio is finally sold. This rule preserves the trust’s function as a stable, passive vehicle that is about holding real estate as an investment, not the active buying and selling of real estate or the expansion of a portfolio.

Sin #2: Renegotiating loans or borrowing additional funds

A DST sponsor cannot renegotiate loan terms or take on additional debt. Too much debt could negatively affect returns, and any additional loans would alter the risk profile of the investment. Keeping the risk profile consistent is important because DST beneficiaries lack voting rights, so the sponsor’s limited activities must be set in advance.

• IRS rule: “The trustee may not renegotiate the terms of the debt used to acquire” any portfolio properties. However, if a loan is defaulted on due to the bankruptcy or insolvency of the master tenant, renegotiation of loan terms could be allowed.
• The downside: The downside of this is that the DST can’t refinance when there is an opportunity to do so. This is a consequence of passive investing: when you actively make decisions on a property, you can decide to refinance or sell early, but with a DST, you don’t have that option. The same is true of the holding period: when it is time for the DST to sell, the properties must be sold, even if it’s not the best market; with an actively-managed property, you could choose when to sell, but with a DST, you can’t.
• Why this matters for 1031 investors: All investors should care about the risk profile of a DST, but for those performing an exchange, the issue is the debt ratio. A DST is designed to take on a certain amount of debt, which is important for those who need to replace debt in their 1031 exchanges. If the debt ratio of the DST changes, it could result in taxation due to a mortgage boot.

Sin #3: Reinvesting proceeds from the sale of the trust’s real estate holdings

• IRS rule: When describing a DST scenario in which money has been received through the selling of trust properties, the ruling simply says, “no reinvestment of such monies is possible.”
• The process: When properties are sold by the trust, the proceeds must be distributed to the beneficiaries. As mentioned, since beneficiaries lack voting rights, it’s crucial that the sponsor not use trust funds outside of the limited way outlined in the offering documents.
• Why this matters for 1031 investors: Imagine you were an investor in a DST, and after one of the properties was sold, the sponsor reinvested the proceeds in a series of NFTs. Not only would this be a risky move you might not approve of, it would change the nature of the trust by involving non-real property, thereby threatening your ability to perform a subsequent 1031 exchange.
• If sales proceeds were used to purchase new property or other assets, you might not receive your full proceeds to perform a new 1031 exchange with. Usually, all DST properties are sold at the end of the holding period; if they weren’t sold at the same time, you wouldn’t be able to perform a single 1031 exchange into a new property or DST, and would instead have to perform multiple smaller exchanges.

Sin #4: Using trust funds for non-approved expenditures

• IRS rule: “The trustee may make only minor non-structural modifications to [a property], unless otherwise required by law. The trust agreement further provides that the trustee may engage in ministerial activities to the extent required to maintain and operate [the DST] under local law.”
• The limits: The DST sponsor can make capital expenditures related to portfolio properties, but only if those expenditures fall under one of three categories, normal maintenance and repairs, minor (non-structural) capital improvements, any upgrades required by law.
• These limitations ensure that the sponsor is able to spend reserve capital to property maintain the properties without allowing for excessive spending. This rule constrains the sponsor to repairs that preserve value without permitting excess risk.
• Why this matters for 1031 investors: Because the sponsor and property manager have a great deal of control in a DST, were they to make a drastic choice with the property, they could be putting your investment at considerable risk. This might prevent them from returning your capital on time (if at all), making it impossible for you to perform another exchange.
• It also matters for Section 1031 rules regarding property held primarily for sale. If the property is not rented during the holding period but instead developed and sold at a profit, this would violate Section 1031 and could invalidate your exchange.

Sin #5: Investing liquid capital in speculative investments

The DST will not invest all of the capital it raises; some will be held in reserve for the types of maintenance and other expenditures described above, and funds earned through the collection of rent are held by the DST between distribution dates. The IRS allows DST sponsors to invest in short-term loan obligations that can be sold prior to each distribution date, but the sponsor cannot invest in higher-risk investments.

• IRS rule: “ Rul. 75-192, 1975-1 C.B. 384, discusses the situation where a provision in the trust agreement requires the trustee to invest cash on hand between the quarterly distribution dates. The trustee is required to invest the money in short-term obligations of (or guaranteed by) the United States, or any agency or instrumentality thereof, and in certificates of deposit of any bank or trust company having a minimum stated surplus and capital. The trustee is permitted to invest only in obligations maturing prior to the next distribution date and is required to hold such obligations until maturity.”
• The goal: Investments can be made that increase the value of the DST’s holdings, but not in a way that limits liquidity for purposes of making distributions. Short-term debt obligations are considered a cash equivalent, so they can be redeemed to make distributions on time.
• Why this matters for 1031 investors: One of the most attractive aspects of a DST for 1031 investors entering retirement is the steady income in the form of distributions. If the sponsor instead invests these funds into risky or illiquid vehicles, distributions could stop without warning. In addition, if cash is invested in a way that changes the DST’s portfolio significantly by including non-real property, it could cause issues with 1031 eligibility.

Sin #6: Not distributing cash reserves to investors

Other than the reserves outlined above, all cash must be distributed to beneficiaries on the schedule outlined in the DST’s offering documents. Earnings and proceeds must be distributed before the agreed-upon distribution date. The Private Placement Memorandum should set the acceptable amount of proceeds withheld for fees and other expenditures, and this limit cannot be violated.

• IRS rule: “The trustee is authorized to establish a reasonable reserve for expenses.” Beyond that, however, “the trustee is required to distribute all available cash less reserves quarterly to each beneficial owner in proportion to their respective interests.”
• Why this matters for 1031 investors: As with Sin #5, this matters when it comes to your income. The sponsor can’t simply withhold distributions from investors, as this is income to which you are entitled as a member of the DST.

Sin #7: Renegotiating leases or entering into new leases

• IRS rule: “The trustee may not renegotiate the terms of the debt used to acquire [portfolio properties] and may not renegotiate the lease with [tenant] or enter into leases with tenants other than [tenant], except in the case of [tenant]’s bankruptcy or insolvency.”
• The solution: This rule ensures consistency, but could be extremely limiting when you consider that some commercial properties have dozens or hundreds of tenants. The way this is solved is through the use of a “master tenant,” set up as a distinct entity from the DST. The trust then enters into a triple-net lease with the master tenant, who sub-leases to the building tenants and is responsible for the management of the individual properties. An exception to this rule is if the tenant is bankrupt or insolvent, in which case it is possible to enter into a lease with a new tenant.
• The emergency provision: There is an additional provision that can be created known as a “springing LLC,” where the DST could be converted into an LLC if the sponsor determines that properties are in danger of being lost due to a loan default. This is worth understanding because if rent is not being collected and the trust is in danger of becoming insolvent, it could be a way to salvage what is left by allowing the sponsor to take actions not permissible under the DST structure.
• Why this matters for 1031 investors: Understanding the true structure of your DST and the relationship with the master tenant will help you better evaluate its reliability as a long-term investment. If a master tenant is not used, then the DST will have far less flexibility if there is an issue with one of the tenants. And if your DST has a springing LLC provision and it is triggered, your tax status as an investor would change greatly.

Ensuring your DST qualifies for 1031 tax deferral

DSTs continue to grow in popularity, and one of the big reasons is that the IRS has offered clarity on how to continue 1031 exchange tax deferral while investing in DSTs. As noted in the Journal of Taxation, “so long as Section 1031 generally remains a viable option for investors seeking tax-deferred real estate exchanges, the syndicated DST structure will remain a cornerstone of the securitized real estate offering industry.”

Avoiding the Seven Deadly Sins of DSTs is crucial not only from an investor perspective, but from a sponsor perspective as well. If sponsors cannot offer their investors assurance that these rules will be adhered to, those who have potentially spent decades building a tax-deferred portfolio will be unlikely to trust their futures with that DST.

JTC works with Delaware Statutory Trusts for the entire investment life cycle, from trust formation to third-party fund administration and investor relations, along with our 1031 Qualified Intermediary services that can facilitate investor exchanges both into and out of the DST. Whether you’re a DST sponsor or a DST investor, you’ll want to work with a trusted name that has the experience to help you execute exchanges that fully comply with all regulations to ensure tax deferral.

Why JTC is the QI of Choice for DSTs