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Editorial 10 MIN READ

The statutory trust, a 2020 field report

Twenty months after we last took the DST temperature, COVID has culled the weak sponsors, the OZ rules finally came into focus, and the mutual-fund chassis kept turning

The Editors
Staff, Incorporator.org
10 min read Updated
Contents 7 sections
  1. What the statute still says, briefly
  2. COVID pressure, and which sponsors felt it
  3. The OZ rules finally firmed up, and the DST question did not move
  4. The §1031 proposed regulations, and what they actually do
  5. The mutual-fund chassis, still
  6. What to tell a client in late 2020
  7. Sources

he Delaware statutory trust outlasted the year that was supposed to break it. Sponsor balance sheets wobbled, retail hotel and student-housing DSTs marked their interests down, and the IRS had to move two sets of calendars to keep §1031 and opportunity-zone clocks from running out during lockdown. The form itself did not move.

This is the field report to our March 2019 revisit, which itself followed the July 2017 primer. Twenty months and a pandemic later, what the DST industry actually looks like on the ground has changed more than the statute ever has. We also walked through the real-estate version at length this summer in how to use a statutory trust for real estate in 2020; this piece is about the market, not the mechanics.

What the statute still says, briefly

12 Del. C. Chapter 38 has not been amended in any operative way since the 2018 Senate Bill 194 changes we covered in the 2019 revisit. The certificate-of-trust requirement under § 3810, the series mechanics under § 3804, the governing-instrument primacy under § 3806, and the beneficial-owner protection under § 3805 all read the way they did eighteen months ago. A DST formed in 2017 with a trust agreement that tracked the statute is still good, and any DST formed since has almost certainly picked up the 2018 electronic-registration language as a matter of form-file drafting.

Rev. Rul. 2004-86 is still the ruling of record for real-estate DSTs seeking §1031 treatment. The seven trustee prohibitions (no new contributions after close, no new investments outside defined short-term instruments, no renegotiation of senior debt, no lease renegotiation or new leases except on tenant insolvency, no more than minor structural modifications, no reinvestment of sale proceeds, and no trustee discretion over cash flow beyond ministerial distribution) are unchanged. The IRS has not revisited the ruling, and the 2020 tax legislation did not touch §1031 in any way that would reopen it.

COVID pressure, and which sponsors felt it

The DST sponsor market in January 2020 was a mature real-estate product category built on broker-dealer distribution, $100,000 minimum check sizes, and twelve to eighteen month holding horizons that usually ended in a sponsor-directed UPREIT exchange into operating partnership units. That distribution worked until March, when the 1031 pipeline froze along with everything else. Relinquished-property sales that were supposed to close in late March and April fell through; identification periods started running on sales that did close; and DST offerings that had priced assuming 2019 cap rates were suddenly holding underwriting that did not survive a zero-revenue second quarter in hotels, student housing, or anything adjacent to urban retail.

The IRS moved first. Notice 2020-23, published April 9, 2020, extended to July 15, 2020 any time-sensitive action that was otherwise due between April 1 and July 15, including the 45-day identification period and the 180-day exchange period under Treas. Reg. § 1.1031(k)-1. That bought the DST industry a quarter. A seller who had closed in early February and was up against a late-April identification deadline could keep looking; a seller who was inside the 180-day window on a relinquished property sold in late 2019 could hold it open. The relief was blunt (it did not extend to actions due after July 15), and the DST desks spent May and June placing investors into the small number of offerings that still looked durable: industrial, medical office, grocery- anchored retail, and multifamily outside the urban core. Hotel DSTs were mostly frozen in the secondary market, because there was no secondary market.

Notice 2020-39, issued June 4, 2020, did the same for the opportunity- zone world (the 180-day investment window, the 30-month substantial- improvement period, the 90% asset test, the 12-month working-capital safe harbor, the 12-month reinvestment period), pushing most of the relevant deadlines out to the end of 2020 or later. The QOF market had less existing inventory to defend than the DST market, so the relief mattered more for deals in formation than for deals in market.

By early fall, the pattern in the sponsor roster was visible. The larger DST sponsors, the ones that had run through multiple cycles and kept underwriting reserves, are still in market with tighter product and narrower asset selection. Several smaller sponsors that had scaled fast on hotel and student-housing product either paused new offerings, sold their pipeline to a larger sponsor, or stopped placing through broker-dealer channels and are effectively out of the market for now. Consolidation that would have taken three to five years of normal attrition happened in six months. A broker-dealer selection committee that had forty active sponsors on its approved list in January has closer to twenty-five in November, and the share of new placements going to the top-ten sponsors is noticeably higher.

The net effect for a prospective investor is fewer offerings but, on the offerings that made it to market, better-underwritten ones. The 6% to 10% offering load and the roughly 1% asset-management fee that the industry normalized on in 2018 are still the industry range. Anyone trying to clear capital through an unusually priced DST (load well above 10%, no sponsor co-invest, a property category nobody else is touching) is a seller in distress, not a product innovator.

The OZ rules finally firmed up, and the DST question did not move

The opportunity-zone regulatory project that was in proposed form throughout 2018 and 2019 was finalized in December 2019, and most of the open questions about QOF structure and QOZB operations were answered by the time 2020 started. Notice 2020-39 added the pandemic extensions on top. None of this changed the answer to the structural question about DSTs.

A QOF must be a domestic corporation or a partnership (including an LLC taxed as a partnership) under IRC § 1400Z-2 and self-certify on Form 8996. A Delaware statutory trust is neither, and the beneficial- owner grantor-trust mechanics under Subchapter J would not survive the 90% QOZ asset test and the substantial-improvement requirement anyway. A DST cannot substantially improve a building without violating the Rev. Rul. 2004-86 prohibition on more than minor structural modifications. The two forms are still pointed in opposite directions, and the 2020 guidance has not nudged them toward each other.

Where the vehicles continue to share investor mindshare is in the after-tax math. An investor with a capital gain in 2020 has three live deferral paths: a §1031 exchange into a DST (real-property gain only, continuing deferral, basis step-up at death on the deferred gain), a QOF investment (any capital gain, partial step-up at five and seven years if held through the pre-2026 cliff, full forgiveness of QOF appreciation at ten years), and an installment sale. The pandemic has actually sharpened the comparison, because real-estate DSTs with durable cash flow look better against a QOF whose substantial- improvement deadline was ticking through a construction-disrupted summer. We are not doing the math here, because it turns on the character and size of the gain and the investor's estate plan, but the answer in October 2020 is different from the answer in October 2019 for any investor whose DST option is an industrial or medical- office property and whose QOF option is a ground-up urban mixed-use development.

The §1031 proposed regulations, and what they actually do

On June 12, 2020 the IRS and Treasury published proposed regulations at 85 Fed. Reg. 35835 that would define "real property" for purposes of §1031 in the wake of the TCJA's personal-property exclusion. The proposed regulations are the first attempt since the 2017 Act to tell practitioners, in regulatory rather than statutory terms, which assets inside a real-estate deal count as like-kind real property and which are personal property that no longer qualifies.

The headline provisions in the proposal treat as real property: land; permanent buildings and inherently permanent structures (including several enumerated examples such as in-ground swimming pools, roads, bridges, fences, permanently installed lighting, and telecommunications towers); structural components integrated with inherently permanent structures; unsevered natural products; and water and air rights. The proposal also treats certain intangible interests (licenses, permits, leaseholds) as real property when they derive their value from real property and are not held primarily for sale. The notable provision for DST sponsors is the functional-use test for items that might otherwise be personal property: a component that serves only the structure it is attached to, contributes to the use of the structure, and is not intended to be moved, is treated as part of the real property.

For a real-estate DST, the proposed rule mostly codifies what underwriters have been assuming since early 2018. A warehouse DST that includes racking, dock levelers, and permanent lighting was already being treated as pure real property under the TCJA. The proposal makes that position more defensible and clarifies a handful of edge cases (billboards, certain signage, fixed partitions) that had been argued both ways. Comments on the proposal closed August 11, 2020. A final rule is expected later this year or early in 2021; we will revisit once it issues.

What the proposal does not do is reopen personal-property exchanges, reopen §1031 for intangibles that do not derive value from real property, or change anything about the Rev. Rul. 2004-86 framework. A DST built on the ruling in 2019 is still built on the same ruling in November 2020, with a slightly clearer regulatory picture of what counts as the "real property" that the ruling treats the DST as holding directly.

The mutual-fund chassis, still

Most DSTs, as in 2019, are not 1031 vehicles. They are open-end management investment companies registered under the Investment Company Act of 1940, organized as series trusts under § 3804, and operated under a trust agreement that uses § 3806(b) to do the work a corporate charter would otherwise have to do. The 1940 Act compliance overlay did not change in any way that matters to the DST form this year, and the pandemic effects on fund flows (record retail equity inflows, volatile fixed-income flows, a wave of new thematic and ESG series launches) played out through the DST chassis without any structural strain.

A fund sponsor launching a new complex in late 2020 will still be steered by counsel toward a Delaware statutory trust. Massachusetts business trusts remain a viable alternative but the deal flow is lopsided. The primary reason the DST wins is the same reason it won in 2017: the Delaware Chancery bench, the statutory flexibility of § 3806, and the segregated-series protection in § 3804 map more cleanly to the way fund complexes actually operate than any other state's trust law.

What to tell a client in late 2020

If the client has a §1031 gain in process and the relinquished-property sale closed inside the Notice 2020-23 window, the first question is whether the extended deadline has been properly documented in the exchange agreement; if it has, the second question is sponsor quality. The DST offerings in market right now are fewer and better, and the right move is to wait for an offering whose asset class and sponsor you already understand, not to force a placement because capital is sitting at a qualified intermediary.

If the client is evaluating OZ versus DST for a fresh capital gain, the conversation is the same one we had in 2019, with the added data point that pandemic-era OZ projects with construction exposure have taken real delivery risk and DST product with durable cash flow has not. That is not a permanent feature of either form; it is a cycle artifact.

If the client is asking whether any of the 2020 IRS or Treasury activity requires action on an existing DST, the answer is no. Notice 2020-23 was a deadline extension, not a structural change. Notice 2020-39 is an OZ extension and does not apply to DSTs. The proposed §1031 regulations are prospective and will not force an amendment to a trust already in service.

If the client is an asset manager launching a fund, the answer is what it has been: the DST is still the chassis, Delaware is still the jurisdiction, and the 2018 statutory amendments are still the last ones that mattered.

The quiet workhorse did a quiet-workhorse year. It carried real freight through a bad road, it lost a handful of drivers who should not have been on the road to begin with, and it is still on the road. What the next twelve months will sort out is whether the final §1031 real-property regulations tighten or loosen the definition, and whether the OZ vintage from 2019 and 2020 produces the kind of write-downs that would reshape the deferral-investor conversation for both forms at the same time.

Sources

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