When Delaware Statutory Trust Trustees' Hands Are Tied: 7 DST 'Deadly Sins'

The Delaware Statutory Trust (DST) is an exceptional investment vehicle. It offers monthly hassle-free income and a more diverse investment portfolio. Managed under the supervision of a trustee, it combines asset protection, estate planning, and personal control.

However, Internal Revenue Ruling 2004-86 names seven deadly sins that limit the DST trustee's power. Below is a list of these prohibited acts, along with an explanation of how the DST can help the investor.

Basics of the DST

The Delaware Statutory Trust (DST) is a formal legal structure that can have multiple beneficial owners, with an underlying trust structure owning the real estate.

The structure can be seen like a “parent” and “child” …. The DST is the parent and each series beneath it is the child. Each series is treated as if it were its own entity, which provides you the same type of asset protection as individual LLCs holding each entity.

A properly structured DST is a haven for California investors looking to avoid franchise tax.  You may elect that it be taxed as an LLC, trust or as a pass-through entity depending upon the manner in which it is formed.

Estate planning is simplified with the DST. The DST can act just like a living trust.  Since all of the assets are underneath one umbrella of control, it becomes exceptionally simple for your heirs to manage. The DST can simply distribute assets to the beneficiaries upon your death or divide ownership interest to your liking. The DST can take advantage of all available tax avoidance strategies.

With the DST you never lose control of your assets. The DST allows you to restrict the ability of the Trustee to act. In fact, the DST can be constructed so that the Trustee cannot act at all and instead all of their powers are conferred upon you as a “managing Trustee." As such, you maintain complete control with the safety of knowing that somebody else cannot unexpectedly sell your property.

DST 7 'Deadly Sins' That Limit The Trustee's Powers

The IRS has specified seven deadly sins that limit the DST trustee's power. Let's look at them one by one.

#1 No future equity contribution is permitted

When you acquire beneficial interests in a DST, you get a percentage of ownership. If a trustee decides to accept additional contributions to the DST after the offering closed, the original investors' ownership percentages will be diluted, decreasing their claim to the DST's assets.

That's why the DST trustee is restricted from borrowing new funds or renegotiating the terms of the existing loans. Trustees are not allowed to assume greater obligations because it can hurt the beneficiaries’ interests.

#2 The DST Trustee May Not Borrow new funds or Renegotiate existing loans

Trustees are not permitted to assume greater obligations because it can lead to a significant impact on the beneficiaries’ interests. Remember, DST beneficiaries do not have the right to vote on operating decisions, and loans are liabilities.

When you invest in a DST, the sponsor will disclose the loan amounts due. Do your due diligence and understand how the liabilities impact the returns before finalizing the investment.

#3 Trustees Can't reinvest proceeds from the sale of DST investments

All proceeds earned by the DST must be distributed to the beneficiaries—not reinvested. Beneficiaries have the right to determine how to use the capital earned from their DST investment. When the assets of a DST are sold, the DST sponsor may create a new DST offering, giving beneficiaries the option to reinvest with the sponsor, but the investor can cash out or reinvest elsewhere.

#4 Capital Expenditures Are Limited

Trustees may spend money to maintain the real estate property and its value, but they can't risk the beneficiaries’ investment to enhance the property when there is no guarantee that the cost of the upgrade will be recovered at the time of sale.

To put it another way: Trustees may reasonably maintain the real estate property and its value, but capital expenditures are limited to standard repair and maintenance, minor non-structural capital improvements and any expenses required by law.

#5 Cash must be invested in short-term debt obligations

Liquid cash retained in the DST between distribution dates must be invested in short-term debt obligations. An investment in a short-term debt obligation can easily be converted back into cash that can be distributed to beneficiaries. As such, it is considered a cash equivalent. This allows the trustee to increase the value of the DST on behalf of the investors without risking the DST's value.

#6 Cash should be allocated to the beneficiaries on a current basis

DSTs can keep cash reserves on hand. This is to help with unexpected expenses, property management, and repairs. However, earnings and proceeds must be distributed to the beneficiaries within the expected timeframe.

This protects the beneficiaries' rights to receive their income in a timely manner and prevents trustee fraud.

#7 The DST Trustee May Not renegotiate Leases

DSTs operate well with long-term leases to creditworthy tenants on a "triple-net" basis (meaning tenants are responsible for paying property taxes, building insurance, and some maintenance expenses, on top of rent and utilities).

A master-lease structure to hold multifamily, student and senior housing, hospitality, and self-storage facilities are also great for DSTs. These leases provide a more secure investment than year-by-year multi-tenant contracts.

Because the IRS prohibits a trustee from renegotiating existing leases or starting new leases, beneficiaries can be assured that trustees will not make risky leasing decisions. Exceptions are allowed in the case of a tenant bankruptcy or insolvency.

The Bottom Line For DST Trustees

These seven deadly sins are in place to allow DSTs to qualify as suitable investments for the purpose of a tax-deferred 1031 exchange. DSTs have benefits for investors, but can create challenges for trustees.

Remember: if a DST is in danger of losing a property because the seven deadly sins prohibit the trustee from taking necessary actions, the state of Delaware permits the DST to convert to a Limited Liability Company ("LLC"), assuming a provision was listed in the origination documents. DSTs are excellent investment vehicles, but you must complete due diligence and choose the right kind of DST for better and secure returns.