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Editorial 9 MIN READ

The statutory trust in the middle of 2020

Thirty months after we first wrote it up, the DST still works the same way; the exchange clock, the sponsor bench, and the investor base around it do not

The Editors
Staff, Incorporator.org
9 min read Updated
Contents 7 sections
  1. What the IRS moved this spring
  2. Why anyone still picks the DST in this market
  3. How the sponsor bench thinned
  4. Still the seven sins, still the springing LLC
  5. What diligence looks like right now
  6. Rule of thumb
  7. Sources

Delaware statutory trust is still the only vehicle the IRS will treat as direct real property for a §1031 exchange, and that has not changed in the thirty months since we walked through the mechanics in January 2018. What has changed is everything around it: a pandemic that parked rent rolls for a quarter, two IRS notices that moved the exchange clock and the Opportunity Zone clock, and a sponsor roster that has quietly thinned.

This is the mid-2020 version of the same conversation. The statute and the ruling are load-bearing; the market around them is what actually dictates whether a DST is a workable destination for a 1031 this quarter.

What the IRS moved this spring

Two notices from Treasury and the IRS reshape the timelines a 1031 investor cares about. Both are pandemic-specific, and the windows are narrower than the press coverage suggests.

Notice 2020-23, issued April 9, 2020, treats any §1031 45-day identification deadline or 180-day exchange deadline that would have fallen between April 1, 2020 and July 15, 2020 as postponed to July 15, 2020. It is not a blanket extension of every exchange in progress. An investor whose 180-day clock expired March 29 got nothing. An investor whose 45-day identification fell on May 1 got a longer, more forgiving window. The notice applies the "time-sensitive act" relief of Rev. Proc. 2018-58 under IRC § 7508A to the COVID-19 disaster declaration; the 120-day standard disaster-relief extension that practitioners reflexively expected does not apply here. You get July 15 and no more.

Notice 2020-39, issued June 4, 2020, is the Opportunity Zone companion piece. The OZ program and the DST market are separate structures solving similar investor problems, and an increasing number of accredited investors weigh one against the other. Under Notice 2020-39, any taxpayer whose 180-day QOF investment window would close on or after April 1, 2020 and before December 31, 2020 now has until December 31, 2020 to invest into a qualified opportunity fund. The 30-month substantial-improvement clock for QOF property is tolled between April 1, 2020 and December 31, 2020, effectively extending it by nine months. Several operational deadlines for QOFs and qualified opportunity zone businesses (the 90% asset test, the working-capital safe harbor, the 12-month reinvestment period) received their own targeted relief inside the same notice.

The practical effect for a seller who closed in January or February is that the OZ path grew more forgiving than the DST path. A 180-day window that would have expired in the summer now runs to year-end; a DST exchange clock running on the same fact pattern got, at best, an additional few weeks. If you are choosing between the two structures for the same capital, the calendar has tilted.

Why anyone still picks the DST in this market

The use case did not move. Sell a rental building, face a §1031 clock, and decline the job of buying and managing another one. Rev. Rul. 2004-86 still says a beneficial interest in a properly structured DST is a direct interest in the underlying real property for §1031. The trust is still formed under 12 Del. C. Chapter 38 by filing a certificate of trust under § 3810. The trustee still holds bare legal title and leases the entire property to a sponsor-controlled master tenant. The seven operational limits we walked through in 2018, the ones practitioners call the seven deadly sins, still govern what the trustee can and cannot do without converting the trust to a business entity and collapsing the grantor-trust treatment that makes the §1031 work.

The one federal tax change since we last covered the structure has now fully settled. The Tax Cuts and Jobs Act (Pub. L. 115-97, § 13303) limited §1031 to real property for exchanges completed after December 31, 2017. Treasury released proposed regulations in June 2020 defining "real property" for §1031 purposes in a manner that broadly tracks pre-TCJA practice and gives sponsors and qualified intermediaries the definitional line they needed. The DST sponsor market, which was always a real-estate play, emerges from all of this more central, not less. Aircraft leasing and equipment finance lost a tool; the 1031-DST complex did not.

The OZ program is the genuine competitor. The two structures are solving similar but not identical problems. A DST accepts a §1031 exchange of real property and defers the gain so long as the investor keeps rolling into qualifying replacement property. A qualified opportunity fund accepts any capital gain, from stock, a business sale, a crypto sale, or real estate, defers it until December 31, 2026, steps up the basis if the QOF is held long enough, and excludes the gain on the QOF investment itself if held ten years. Different income types feed each vehicle. Different holding periods and different exit economics follow. DST investors who were not going to do a §1031 never had an OZ alternative; DST investors who sold appreciated real estate now reliably stress-test both.

How the sponsor bench thinned

Three shifts in the sponsor market are worth naming. None is dispositive for any single deal, but together they change what diligence looks like.

The first is consolidation at the top. The DST sponsor industry has been a long tail of mid-sized real-estate operators plus a short list of large, broker-dealer-distributed firms. Over the last two years the short list has grown shorter, through acquisitions, rebranding, and sponsors winding down their DST programs to focus on other structures. An investor who placed with a mid-tier sponsor in 2017 and expected the same distribution cadence through 2024 has in several cases been introduced to a different entity servicing the trust.

The second is property-type rotation inside the programs that are still active. Multifamily remained the anchor through the spring, and sponsors who held institutional-grade apartments collected rent through the worst weeks of the shutdown with less disruption than the commentary predicted. Single-tenant net-lease retail (the Walgreens or CVS pad, the Dollar General, the freestanding medical clinic) has become more prominent precisely because credit-rated tenants under long-dated triple-net leases paid through the lockdown. Hotels and non-trophy office are largely absent from new DST offerings that launched in the last four months, for reasons that need no elaboration.

The third is the sponsor-level operations question. The DST is structured so that the trust itself does nothing operational; the master tenant handles tenants, capex, and leasing. That delegation worked as designed in March and April. Investors who had not previously focused on the credit and operational capacity of the master tenant discovered that they should have. A master tenant that is a thinly capitalized sponsor affiliate, obliged to pay a fixed rent regardless of what the property's actual rent collections look like, is a covenant dependent on the sponsor's balance sheet. Most held. Not all.

Still the seven sins, still the springing LLC

Because investors who read this piece later will ask, and because the pandemic generated a real set of fact patterns where sponsors had to decide whether to touch a debt stack or a lease, the structural prohibitions are worth a re-read.

No new capital contributions after closing. No renegotiation of the existing debt, including loan modifications that a lender offers unsolicited. No reinvestment of sale proceeds. No change to the master tenant or master lease absent an actual default. No renegotiation of existing leases other than automatic adjustments the original documents already provide for. Cash reserves restricted to short-term debt obligations. A limited holding window for cash between distributions, which sponsors typically treat as no more than ninety days.

Treat any of those as soft and the trust converts to a business entity under Treas. Reg. § 301.7701-4(b), the grantor-trust treatment under § 301.7701-4(c) disappears, and every investor's §1031 exchange on the way in becomes a retroactively taxable sale. That is the nuclear outcome; it is also the reason sponsors move the deck to a "springing LLC" when an actual crisis hits the property.

Every well-drafted DST trust agreement contains a springing provision. If a balloon comes due and the trustee cannot refinance, if the master tenant defaults and a lease needs to be renegotiated from scratch, if the building suffers a casualty, the trustee can convert the DST into a Delaware LLC and act like a normal real-estate operator. Conversion after closing does not unwind the §1031 treatment the investor banked on the way in; it does eliminate §1031 treatment on the way out, which is a problem for the investor's next exchange but saves the property. Several 2020 programs have already gone through the internal analysis of whether to spring. To our knowledge, none of the major sponsors publicly converted a DST in the first half of the year, but the contingency plans came off the shelf.

What diligence looks like right now

The three traps we named in 2018 are the traps we would name again, with one adjustment for the current cycle.

Concentration at the sponsor level is still the failure mode that bites. An investor selling a $4 million portfolio who splits into four DST offerings from the same sponsor has not diversified. They have concentrated into one sponsor's underwriting, one sponsor's master-tenant credit, and one sponsor's ability to extend a loan at maturity. If you can reach two or three sponsors you have actually read on, do that. If one sponsor has the allocation you need, ask the QI about holding a portion in an alternate structure (a §1031 DST plus a 721 UPREIT contribution, for instance) rather than doubling up.

Fee load is still the diligence line. Sponsor fees, acquisition fees, loan fees, asset-management fees, and disposition fees are disclosed in the PPM and add up. Projected IRRs are net of these. Ask for the gross-to-net waterfall on a comparable prior deal, not on the subject offering, because the subject offering's projections are the sponsor's forward view and the prior deal's numbers are history.

Exit timing is the new item. In a normal cycle the investor is a passive beneficiary of the sponsor's sale decision. In a cycle where property values are being revalued quarterly and lenders are renegotiating maturity walls at the edges, the range of sponsor exit outcomes widens. The investor who expected a five-year hold and the investor who gets an eight-year hold both receive the same grantor-trust letter; their realized IRRs are different. The current environment makes that range wider than it has been at any point since the DST market's post-2008 growth phase.

Rule of thumb

If you are in a §1031 window in mid-2020 with real-property sale proceeds and no appetite for landlord work, a DST is still the only vehicle that both preserves the exchange and delegates management; check whether Notice 2020-23 moved your deadline before doing anything, weigh the OZ path that Notice 2020-39 just extended to year-end, and if the DST is the answer, spread across two sponsors and read the master-tenant credit the way you would read a corporate bond.

Sources

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