Monthly Archive: February 2014

Delaware Statutory Trust Section 1031 DSTs

Submitted by Chris Moss CPA

In my past blog in December 2013 I briefly discussed the Delaware Statutory Trust (DST) as a possible investment for 1031 tax free exchange deals but concluded that Tenant in Common (TIC) deals were better for entrepreneurs and small business owners. In this February 2014 blog I am recommending DST for retired or soon to retired accredited investors and less risk taking baby boomers who have substantial assets generating no income with a very low cost basis. Here is why:

Are you the owner of a large track of land that may be ripe for development? You want to sell, but your cost basis is very low or zero and the tax upon sale would be very high. Perhaps a DST is right for you. A DST is an investment trust classified by the IRS as a qualifiying investment for tax free recognition under Section 1031 of the IRS code. For those interested in the IRS revenue ruling 2004-33 here is the site:
IRS Letter Ruling 2004-33

If you read the ruling you may agree with me that how the IRS takes the facts in the above case and applies these facts to current law to create this ruling defies logic. Yet thanks to logic defying IRS ruling 2004-33, DSTs are a great opportunity for baby boomers who are retiring or about to retire to sell their non-income producing assets with a low cost basis and replace those assets with income producing commercial real estate all tax free under Section 1031.

Let’s take an example: You own 1000 acres of forest land worth $10 million which has potential for mining or timber production. Or perhaps you are thinking about real estate development on a large tract which is currently your main residence or second vacation home. Or perhaps you own a ranch or farmland that has potential for gas/oil development and have been approached by a fortune 500 company to sell them the mineral rights. Upon sale of any of these investment strategies you want to invest the proceeds in the stock market and live off the dividends. But your CPA says you have a very low or even zero cost basis in all these assets. As a result upon sale your tax bill would be so high that you would only receive $5 million of the revenue with the remaining $5 million going to IRS and the various states. If you were to take that $5 million you receive and put that money in the stock market do you really want to wait out another market recovery if the market crashes like it did in 2008?

Your tax attorney tells you about the DST. You sell the land for $10 Million and your qualified intermediary (QI) is wired the funds. You have 45 days to find a replacement property and 180 days to close the deal. Your investment advisor finds you a wonderful DST, an ABC pharmacy in Las Vegas with a 20 year triple net lease in a $120 Million Condo on the upper Strip past the CDF Hotel. There is 50% equity and 50% debt so for your $10 million you can purchase up to $20 million in ownership in this DST with an expected rate of return of 7.25 percent a year. You get monthly distribution checks for the duration of the investment and upon termination of the deal you can either pocket the $10 Million or roll the deal over again in another 1031 exchange. Here is another plus: these deals only require the Trustee called the Sponsor to be liable for the mortgage. You the investor (beneficiary), have nonrecourse debt and you are not liable on the mortgage. Since nonrecourse debt increases your cost basis for income tax purposes that means higher tax deductions for you with no risk on the debt. There is only one tenant for 20 years and the lease is guaranteed by the ABC pharmacy national corporate office in Chicago. So what’s not to like about this DST.

Well for some folks there is one thing not to like about a DST. And this is a very big thing not to like. Unlike very fluid TIC deals, DST’s allow no changes. No new lease, no new tenant, no capital improvements, no new mortgage, no new investment no new nothing and very important to some investors, no voting rights, There is one way for an investor to make changes but very complex: If the sponsor gives you and everyone else who are beneficiary investors permission to make a change, you must first change the DST to an LLC. This is called a “Springing in LLC conversion” The problem is that Once the DST is converted you can’t qualify for 1031 deals in the future. You can convert back to a DST called a Springing out DST conversion but very complex. Unfortunately there is not a lot of tax guidance in case law from the US Tax Court just yet. If you are in a DST and want to make a changes and get permission to do so, please consult your CPA, Tax Attorney and Investment advisor and get them all in the same room to talk with you since converting a DST to an LLC is very complex and very risky.

In conclusion a DST is preferable to a TIC for purposes of 1031 tax free exchange for perhaps accredited baby boomers retired or about to retire who want to pass on the TIC deals requiring your active involvement and purchase beneficial interests in real estate handing over the management to the Trustee-Sponsor of the DST. The result is a tax free conversion of your land, acreage, or other similar investments to commercial real estate producing monthly rental income for you and your family. Pleases consult your attorney CPA and investment advisor before attempting any of this as DSTs are complex tax strategies for accredited investors. See you next month from Chris Moss CPA