Question: How can a US taxpayer (“Sponsor” or “Developer”) obtain investors (including 1031 investors) in an investment while maintaining control of the investment?
Answer: use a Delaware Statutory Trust (“DST”). The choice involves some restrictions but it can work well in the right situation.
Limited Liability Entity. A DST formed for investment purposes is recognized by the State of Delaware as a separate legal entity. It issues certificates to its beneficiaries (aka owners). Under Delaware law, it may sue or be sued and beneficial owners have limited liability like the shareholders of a corporation. A creditor of an owner may not assert a claim against the assets of the DST. The interests in the DST are freely transferable; but, may not be publicly traded on an established security market. The DST may not act as an agent of the owners.
Owner Control. The trustee is severely restricted from exercising control over the assets of the trust. The trustee may not have the power to vary the investments of the trust including a managerial power to buy or sell assets to take advantage of variations in the market to improve the investment of the investors. In effect, the trustee may not carry on a profit making enterprise. But, the trustee can own as an investment an entity that carries on a profit making enterprise. Rev Rul 2004-33. The trustee is generally required to distribute all of the net income quarterly to the owners. Owner beneficiaries are also strictly prohibited from exercising any control over the assets of the trust.
1031 Exchange. An owner can exchange its interest in any real estate investment for a certificate in a DST.
Analysis:
Tax Classification of Delaware Statutory Trust.
The DST must be carefully created to avoid being treated for tax purposes as either an agent of the owners or a partnership with the owners. For US tax purposes, the DST is either a trust or a business entity. Reg 301.7701-4(c)(1). The key fact is whether the trustee of the DST has the power under the trust agreement to vary the investments of the trust.
In order to not be held not to be engaged in a profit making business, the DST should only receive assets and assume liabilities of known unvarying amounts. For example, a shopping center that entered into a 10 year lease with a tenant, and was subject to a nonrecourse loan with a term of at least 10 years could be validly owned by a DST with a 10 year term. The trust agreement should provide that the trustee’s activities are limited to the collection and distribution of income.The trustee may not exchange the shopping center for other property, purchase assets other than short-term investments such as the demand bank account or short-term money market account, or except additional contributions of assets (including money) to the DST.
Exchange of Real Property for DST interests under Section 1031.
The owners are treated as grantors of the DST under regulation 1.671 – 2(e) (3) when they acquire their interests in the trust. Because they have the right to distributions of all trust income attributable to their undivided fractional interest in the trust, the owners are each treated, by reason of section 677 as the owner of an undivided portion of the trust and all income deductions and credits attributable to that portion are included by each of them under section 671 in computing their taxable income.
The exchange of real property interests for certificate of ownership of a portion of DST is treated, for tax purposes, as an exchange of the real property interests for a portion of the underlying real property assets of the DST. Section 1031 (a) (2) (E). So long as all of the requirements of section 1031 a satisfied the exchange of real property for an interest in the DST will qualify for nonrecognition of gain or loss under section 1031. The same result would occur if the owners exchanged real property with a third-party and immediately formed the DST by conceding their interests in the real property received.
Caveat.
The DST will be treated for tax purposes as business entity (either partnership, corporation or sole proprietorship) if trustee has additional powers under the trust agreement such as the power to:
1. Dispose of the real estate and acquire new property;
2. Renegotiate the lease with the current tenant or enter into leases with tenants other than the current tenant;
3. Renegotiate or refinance the obligations used purchase the real estate;
4. Invest cash received to profit from market fluctuations;
5. Make more than minor nonstructural modifications to the real estate not required by law;