The 7 Deadly Sins of DSTs: IRS Revenue Ruling 2004-86 Explained

1. Loan and Refinancing Restrictions

A DST is strictly prohibited from renegotiating existing loan terms or securing new financing. This restriction helps maintain the passive investment status required for 1031 exchanges. However, investors may miss opportunities to refinance at lower interest rates, potentially boosting cash flow.

Furthermore, DST properties might be forced to sell upon loan maturity, even if market conditions are unfavorable or the asset faces temporary challenges, potentially leading to a loss for the sponsor and investors. For business plans requiring flexibility or relying on refinancing, alternative syndications like Tenants in Common (TICs) might be more suitable replacement property 1031 options.

2. New Leasing and Renegotiation Prohibitions

DSTs are prohibited from entering new leases or renegotiating existing ones. This presents a challenge for properties with high tenant turnover, such as multifamily or self-storage facilities. Sponsors often navigate this by establishing a subsidiary that master-leases the property from the DST, allowing the subsidiary to manage subleases freely.

However, this can create complex legal structures with unclear cash flow strategies and potential hidden tax implications. Always consult a qualified intermediary and your advisor before investing in such structures.

3. Major Capital Expenditure Limitations

Significant capital improvements or repairs beyond routine maintenance are forbidden for DSTs. Major expenditures could fundamentally change the investment's nature, risking its 1031 exchange eligibility. While this rule promotes a conservative business plan, appealing to many passive real estate investors, it may not align with those seeking value-add or development-oriented deals with higher return potential.

For these investors, TICs, LLCs, or REITs might better serve their investment objectives, as they allow for more substantial property enhancements.

4. Property Sale Proceeds Distribution Requirements

If a DST sells a property, the proceeds must be distributed directly to investors, not reinvested in new properties. This means a sponsor cannot buy and sell properties within the DST; the trust is limited to the properties it initially acquired.

While sponsors typically aim to sell the entire portfolio simultaneously, a partial sale can lead to complicated and potentially frustrating tax situations, underscoring the importance of understanding all 1031 exchange rules.

5. Excess Reserve Distribution Requirements

DSTs are permitted to hold limited capital reserves, typically around 3% of the property's value. These reserves are exclusively for normal maintenance and operations, not for significant improvements, and must be held in short-term investments like cash management accounts. Any excess reserves must be distributed to investors, promoting greater transparency and accountability.

This benefits investors by ensuring they receive cash flow as it's earned, rather than waiting for a property sale. However, sponsors sometimes need to build larger cash reserves to anticipate future economic or operational challenges.

6. Business Operations Prohibitions

A DST cannot engage in any business operations beyond collecting rent and paying property management expenses. Any other business activities could alter the DST's fundamental nature, jeopardizing its 1031 exchange eligibility. Consequently, revenue from a DST can only be used for three purposes:

This restriction can be appealing to investors as it limits the sponsor's ability to mismanage cash through poor or irresponsible investments.

7. Future Capital Contribution Prohibitions

Investors cannot make additional capital contributions to a DST after their initial investment. Similar to the refinancing restriction, a DST is not allowed to raise additional equity from investors. This ensures the investment remains static and prevents modifications that could compromise the trust's nature.

The inability to conduct capital calls often requires sponsors to maintain substantial reserves, which may become taxable if too large and are restricted to property expenses. Some investors prefer entities that allow capital calls, offering flexibility to inject additional capital when needed while keeping initial funds invested elsewhere.

Investors who prefer to keep cash out of the deal initially, allow the sponsor more flexibility, and then potentially have to add cash through a capital call throughout the life of the property, might find TICs a more suitable option.

Balancing Restrictions with Investment Security

At the end of the day, these restrictions can be positive because they often mean more certainty and stability for investors. However, if things do not go according to plan, they can pose a real risk if a sponsor needs to step in and break one of the rules in order to improve performance on a property that is facing challenges.