Delaware Statutory Trust
In recent years, there has been a significant effort on the part of TIC Sponsors and lenders to develop a co-ownership structure that overcomes the limitations of traditional TIC offerings. This has given rise to an alternative structure for co-owned real estate called a Delaware Statutory Trust (DST).
On August 16, 2004 the IRS issued Revenue Ruling 2004-86, allowing the use of a DST for co-owned real estate where 1031 exchanges are involved.
Limitations of TIC Offerings
In order for a TIC offering to be considered a real estate transaction for 1031 exchange purposes, it must follow the guidelines established in Revenue Procedure 2002-22. One of the guidelines states that there can be no more than 35 co-owners. This limitation effectively restricts the size of real estate transactions, as the investment minimum increases along with the purchase price of the property. For example: a building that costs $150 million, with financing of $75 million would require a minimum investment of $2,142,857 ($75,000,000/35). As minimums increase, it becomes more difficult for TIC sponsors to assemble an investor group.
Another limitation is the logistical effort required to create as many as 35 single purpose entities (LLC's) and simultaneously underwrite and close multiple loans. Lenders frequently limit the number of co-owners in a TIC transaction to fewer than 35 in order to make the underwriting and closing process less cumbersome.
Investor Benefits of a DST
Unlike a TIC transaction, there is no need under the DST structure to set up an LLC for each investor. Instead, each investor owns a beneficial interest (BI) in the DST. The DST itself shields the investor from any liabilities with respect to the property. This saves the investor substantial money with respect to the formation costs and annual fees for maintaining an LLC. It also provides a less complex structure for the investor.
Unlike a TIC transaction, which requires that co-owners vote unanimously on all major decisions, a BI holder in a DST is not permitted to vote. Therefore, the concern over the "rogue investor" is eliminated.
Because the DST (and not each investor) is the borrower, there is no need for the lender to obtain tax returns, financial statements, and credit authorizations from each investor for purposes of loan qualification.
In a DST transaction, the trust owns 100% of the fee interest in the real estate, so unlike the TIC structure, there is only one loan and one borrower. There is also no restriction on the number of investors in a DST, as opposed to a TIC transaction, which is limited to 35 investors. As a result, larger properties can be purchased without causing investment minimums to rise to unacceptable levels.
Most importantly, a DST is an acceptable structure for 1031 tax deferred exchange transactions.
Lender Benefits of a DST
A DST prevents potential creditors of the investors from reaching the DST property. This provides the lender greater security in having the ability to foreclose on the first mortgage of the property should the need arise.
Unlike a TIC structure, there is no one-year time limit on the term of the property manager. This will give the lender comfort in knowing that the sponsor will be operating the property without interruption.
The lender does not need to qualify any of the investors because they are not the borrowers, nor do they have the power to negatively impact the loan. Not having to qualify each investor saves time and money.
IRS Requirements of 2004-86 Causing Lender Concerns
Internal Revenue Ruling 2004-86, which forms the basis for a DST transaction has prohibitions on the powers of the trustee, which have become know as the "seven deadly sins." They are:
- Once the offering is closed, there can be no future contribution to the DST by either current or new beneficiaries.
- The trustee cannot renegotiate the terms of the existing loans, nor can it borrow any new funds from any party.
- The trustee cannot reinvest the proceeds from the sale of its real estate.
- The trustee is limited to making capital expenditures with respect to the property to those for a) normal repair and maintenance, (b) minor non-structural capital improvements , and (c) those required by law.
- Any cash held between distribution dates can only be invested in short-term debt obligations.
- All cash, other than necessary reserves, must be distributed on a current basis, and
- The trustee cannot enter into new leases or renegotiate the current leases.
The Springing LLC as the "Emergency Parachute"
A DST agreement may contain a provision that provides that if the trustee determines that the DST is in danger of losing the property due to its inability to act because of the prohibitions in the trust agreement (the seven deadly sins), it can convert the DST into a limited liability company (the Springing LLC) with pre-existing agreed-upon terms. Delaware law permits the conversion through a simple filing. The Springing LLC will contain the same bankruptcy remote provisions as the DST (for the lender's benefit), but it will not contain the prohibitions against the raising of additional funds, the raising of new financing or renegotiation or the terms of the existing financing or entering into new leases. In addition, it will provide that the trustee (or sponsor) will become the manager of the LLC.