The Seven Deadly Sins of a DST | IRS Restrictions Every 1031 Investor Must Know (Episode 2)

Hello and welcome to the exchange, your resource for 1031 market intelligence and education. My name is Tom Wall, partner here at Anchor1031, and this is episode two of our four-part series discussing the structure of a DST. This episode is one of my favorites where we take a look at the seven deadly sins of a DST. I'll give investors an overview of the restrictions that the IRS has put on DSTs to make it eligible for a 1031 exchange.

So, to jump right in, the concept of the seven deadly sins of a DST refers to a specific set of activities that a DST sponsor has to avoid in order to maintain the trust tax advantage status per the IRS's revenue ruling 2004-86. These restrictions are crucial for ensuring that this DST qualifies for 1031 exchange purposes and in a lot of ways it informs the type of assets that DST sponsors ultimately buy and choose to put in the DST structure. So to understand the seven deadly sins is to understand the DST marketplace.

In some ways, these rules force the sponsor to be transparent and limit the opportunity for a sponsor to actually mismanage an asset. However, they can also be very restrictive. They can limit upside potential and pose challenges for certain investments.

So, without further ado, here are the seven deadly sins of DSTs. Number one, there's no renegotiating of terms of existing loans or entering into new loans. Number two, there's no leasing or renegotiating existing lease. Number three, there are no major capital expenditures allowed. Number four, no reinvesting proceeds from a sale of a property. Number five, excess reserves must be distributed to investors. Number six, no business operations are allowed. And number seven, no future capital contributions, which means capital calls are prohibited.

Now, let's take a deep dive into each sin.

Sin number one, no renegotiating loans or entering into new loans. The DST cannot refinance, modify the terms of, or take on new debt. The reasoning here is if the DST could take on new debt, it could fundamentally alter the risk profile that investors signed up for. So, before a DST ever comes to market, the loan structure is going to be set by the sponsor. They're going to go and get the financing, and they're going to underwrite the deal with a certain loan amount, with a certain amount of equity raised, and a certain debt service coverage ratio. So, once those projections are in and the deal is brought to market, the sponsor cannot go back and alter the financial leverage on the property.

This does have some trade-offs. We typically see new loans with more favorable terms as time passes and interest rates change. If a DST is locked into a higher interest rate loan, it is unable to refinance to take advantage of those lower rates. On the flip side, if we see rates go higher, the DST would be insulated from rising interest rates.

Sin number two, no leasing or renegotiating existing leases. The DST cannot enter into new leases or renegotiate the existing lease terms. This can be problematic if a tenant wants to leave early or if market rents have changed significantly. For example, if market rents increase and your tenant's lease is up for renewal, the DST cannot negotiate a higher rent. That means investors may miss out on additional income. Conversely, if rents go down and your tenant doesn't renew, you may be stuck with a vacant property with no ability to sign a new lease.

This is one of the main reasons why triple net properties are so popular in the DST space. Long-term triple net leases align well with this restriction because they provide for long-term stable income with minimal lease negotiations.

Sin number three, no major capital expenditures. The DST cannot make structural improvements or significant repairs beyond what's already been budgeted for. So, any capital repairs need to be anticipated ahead of time and built into the budget, but unexpected major expenses could pose a challenge. This restriction helps preserve the passive investment nature of the DST. DST investors should not expect to have to contribute capital to make repairs, and so this is how that's kind of achieved in the DST structure. Again, this is one of the reasons that triple net properties are so popular. NNN tenants are responsible for most property expenses, including maintenance, repairs, and capital improvements, which eliminates this risk for the DST and its investors.

Sin number four, no reinvesting proceeds from a sale. If the DST sells an asset, the proceeds cannot be used to purchase new assets within the trust. This is particularly relevant for DSTs that hold a portfolio of properties. If one asset sells, those proceeds are distributed to investors. The DST structure actually has investors on title, and so investors own their pro rata share of every property in that portfolio. So, if a property sells, the investors actually own their pro rata share of the sale. When it comes to their 1031 exchange, they can either roll those proceeds, just the amount from the property that was sold, into a new DST, or they can take that money and pay taxes and deploy it elsewhere.

Sin number five, distribute excess cash. So, essentially, the DST is required to distribute any excess cash flow to investors. It cannot accumulate large reserves beyond what's necessary for operations. In practice, we see most DST sponsors hold a reasonable amount of cash in reserve for unforeseen circumstances, but the excess must be paid out. Reserves are reviewed on a regular basis. We see some DSTs hold back reserves during the early hold period when there's a lot of uncertainty, and then distribute excess reserves later.

Sin number six, no business operations. The DST is prohibited from engaging in active business operations. This means the trust can only collect rents and hold real estate. It cannot offer services or manage businesses. This keeps the DST as a passive investment and preserves its status as a trust for tax purposes.

And finally, sin number seven, no capital calls. The DST cannot accept additional capital contributions from investors after the initial offering period. If additional funds are needed for any reason, they have to come from other sources, not from the investors. This protects the investors from any unexpected funding requests.

So, in summary, the seven deadly sins are designed to maintain the DST's tax-advantaged status while keeping it a passive investment for investors. They impose real limitations that sponsors and investors need to work within. However, they also provide structure and protections that many investors appreciate.

So now you have an understanding of the seven deadly sins of a DST. Make sure to stay tuned for episode three where we discuss the master tenant lease, a creative solution that sponsors use to work around some of these restrictions. If you're interested in learning more about DST investments, please check out anchor1031.com, and thank you for watching.