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Financing Real Estate Acquisitions in the World of DSTs

by Lindsey Whitlow, Esq.

The Real Estate and Finance practice group at MRC frequently serves as counsel for clients acquiring and financing real property, specializing in representing clients (“Sponsors”) in real estate acquisitions in which the acquired property is intended to be utilized as an investment vehicle under Section 1031 of the Internal Revenue Code.

Background
At its core, Section 1031 allows investors to engage in tax-deferred like-kind exchanges for the purpose of investment. In a deferred exchange, the proceeds from the sale of one piece of real property are utilized to purchase another piece of real property, or a portion thereof. Section 1031 allows investors to subsequently defer long-term capital gains from the sale of the original property, for as long as the new property is held for investment purposes.

However, Section 1031 is nuanced. There are several pitfalls and subtle traps that the uninitiated, and even experienced investors, should be aware of when acquiring and financing investment property under this Section. This article is meant to highlight the importance of engaging counsel that is experienced in the realm of 1031 exchanges, and the most common structure used today to effectuate 1031 exchanges, Delaware statutory trusts (“DSTs”), to avoid an expensive misstep.

DSTs are often used as a mechanism for investors to purchase fractional interests in larger, more sophisticated properties than the investor could purchase outright on its own.  (For a more detailed discussion, see It’s Always Sunny in Delaware).

Investors in DSTs use the proceeds of the sale of their original property to purchase beneficial interests in a DST, which owns a replacement property. Though the beneficial interests in the DST may not appear to be “real property” on the surface, IRS Revenue Ruling 2004-86 confirmed that beneficial interests in a DST may qualify as replacement property if the transaction is properly structured. Therefore, Sponsors should be on the lookout for potential issues early in the acquisition and financing process to preserve investors’ exchanges down the line.

Nuances of a DST Acquisition and Financing
The best way for Sponsors to avoid issues that may unravel a 1031 exchange using the DST structure is to engage experienced counsel early—in fact, whenever feasible, Sponsors should secure DST counsel even before a letter of intent to purchase commercial property, and certainly before a senior loan term sheet has been signed.

Acquisitions
With regard to acquiring a property that will be syndicated to investors, there are certain items that often get overlooked in the negotiation of purchase and sale agreements (“PSAs”). Per IRS guidance, DSTs are limited in what actions they can take once they own real property. This means that PSAs should account for these restrictions, particularly when negotiating closing documents and assignment provisions. Below are a few examples of features unique to DSTs that Sponsors and their attorneys should look out for:

• Any assignment of leases and contracts should reflect the DST as owner of the real property
• In some states, it is difficult or even impossible to convey a deed directly to a DST and conveyance will be to the trustee
• As a buyer, a Sponsor may need the cooperation of the seller in working with a Qualified Intermediary of a 1031 exchanging taxpayer

Financing
A borrower has much more leverage in loan document negotiations at the term sheet stage than later in the process. Certain DST-specific provisions should, wherever possible, be baked into the term sheet itself. For instance, under standard loan documents, lenders are reticent to allow the borrowing entity to transfer more than 50% of its ownership to other parties. In a DST structure, the goal is for all of the beneficial interests in the DST to be sold to investors. While beneficial interest holders have no management authority or voting power, the sale of 100% of the beneficial interests without express language allowing such a transfer would traditionally result in a default under the loan. When lenders are aware of and agree to the DST structure and requirements prior to drafting the loan documents, this concept can be included in the loan agreement without causing the lender to go back to its authorizing committee. While there are any number of subtle and important snares to avoid, below are a couple of deal-breakers if a Sponsor is to keep its DST compliant with Section 1031:

• It is important to limit the scope of non-recourse carve out exceptions
• Reserves should very narrowly conform with requirements for the DST under the Revenue Ruling

Takeaway
There is not an immense amount of guidance from the IRS regarding the use of DSTs in Section 1031 exchanges. What guidance we have requires transactions to meet to a certain standard in order for investors to maintain their ability to defer capital gains taxes. The above-highlighted issues can often be the tip of the iceberg when it comes to potential hazards Sponsors must navigate to ensure their DST remains compliant, and the risk to 1031 investments is minimized. Engaging experienced counsel early could be paramount to these goals.