1031 Exchange Guide: Tenants-In-Common & Delaware Statutory Trusts

1031 Exchange Guide: Tenants-In-Common & Delaware Statutory Trusts

Nov 07, 2019

Investors utilizing a 1031 exchange have multiple options for investing real estate sale proceeds. In this article, we will provide a summary review of two widely-used investment vehicles - Tenants-in-Common (TIC) and Delaware Statutory Trust (DST).

Tenants-in-Common (TIC)

Since the early 2000s, 1031 exchanges into professionally-managed portfolios have been used by those wishing to shed landlord responsibilities while continuing to reap the benefits of a 1031 exchange.Before the DST became a popular funding vehicle, a TIC was often utilized.

Although the TIC structure of a 1031 exchange was e stablished in the early 1990s, it became popular when the Treasury Department issued Revenue Procedure 2002-22, which effectively approved the use of the TIC structure for 1031 exchanges. Under the TIC structure, each TIC owner holds a direct ownership position in the property, which qualifies as a like-kind exchange. Each TIC owner(either directly or through a disregarded entity) holds title in the form of a deed to the property and retains voting rights on major decisions concerning the property. (1)

The TIC structure typically works well for property owners looking to roll smaller exchange positions into larger assets alongside other property owners looking to do the same thing. Also, the TIC structure may allow property owners to exchange into a property alongside operators who have specific property expertise or uniRue business plans that meet the TIC owners’ investment objectives.

However, during the 2008 downturn, many of these structures began to fall apart and quickly proved to be an administrative nightmare. There are certain limitations to note within the TIC structure.

TIC Limitations

  • The TIC structure allows only 35 property owners, and each owner is a borrower on the mortgage, which requiresunderwriting and monitoring for each TIC owner

  • It is often recommended that each TIC owner set up a single member LLC to protect his or her personal assets shouldthe TIC file for bankruptcy

  • The IRS limit of 35 TIC owners can put constraints on the size of property that may be purchased, forcing high minimuminvestments

  • TICs require a unanimous vote to raise more capital or sell the property, which can be difficult if each owner has differentmotivations and objectives

During the 2000s, TICs initially enjoyed immense popularity because cash flow and property values were strong. However, during the 2008 downturn, many TIC structures fell apart because they could not receive the unanimous approval necessary to navigate the slowdown in the real estate market.(2)

Delaware Statutory Trust (DST)

1031 exchanges can be a valuable tax and business strategy for property owners who wish to sell and buy property(ies). However, in some cases, property owners wish to rid themselves of the “three Ts” (toilets, trash, and tenants) and move to a more passive investment for either management relief or for additional diversification. Often times, these property owners have an eye on retirement and no longer wish to manage a property. Or, the property owner inherited the property and wants to shed the responsibility of ownership. In these cases, a property owner may wish to consider a DST.

In 2004, the IRS released Revenue Ruling 2004-86, which provided instruction on how to structure a DST so that it would qualify as a replacement property of a 1031 exchange.(3)This was music to the ears of property owners who had become frustrated with the limitations and administration of TICs, especially in the period following the Great Recession.

A DST is derived from Delaware statutory law as a separate entity created as a trust. Each property owner looking to complete a 1031 exchange can buy an ownership interest in the trust that holds title to the underlying properties. Unlike the TIC structure, the owners of a DST are passive investors with limited, if any, voting rights within the DST. However, because the trust is a single entity, lenders may look more favorably on the DST structure than the TIC structure where there are multiple borrowers and property owners.(4)

Rather than exchanging into a single asset, property owners who exchange into a DST may have an option to invest in a portfolio of assets that have the ability to provide a diversified income stream and access to potentially higher-quality assets. While this may seem similar to other multi-building real estate offerings, such as a public or non-traded REIT, a beneficial interest in a DST is considered a direct interest in the replacement properties, therefore qualifying the property owner for a 1031 exchange.

Ultimately, DSTs are passive investments. The portfolios are typically established with a goal of providing ongoing, consistent distributions to the property owner.

DST Limitations

Though less limited in structure than a TIC, it is important to be aware of the limitations of a DST:

  • Once an offering is closed, there can be no additional equity contributions to the DST by either current or new investors

  • The trustee of the DST cannot renegotiate the terms of the existing loans, nor can it borrow new funds from anyother lender party

  • The trustee cannot reinvest the proceeds from the sale of investments; all distributions must be paid to the investors

  • Any liquid cash held in the DST between distribution dates can only be invested in short-term debt obligations

  • All cash, other than necessary reserves, must be distributed to the co-investors or beneficiaries on a current basis

  • The trustee cannot enter into new leases or renegotiate the current leases

There is a safety net if these limitations place a DST at risk. The state of Delaware permits a DST to convert into a “Springing LLC.” This can allow the DST to raise new funds and/or refinance its properties. However, this may have tax consequences and is often only utilized when absolutely necessary. (5))

Summary

There are several options for those looking for tax-deferral strategies within a real estate portfolio. Like any tax-deferral strategy, property owners should understand the benefits and drawbacks of the various options and should work alongside their attorneys, accountants, tax counsel, and financial advisors. At Platform, we understand the potential pitfalls and possible advantages of 1031 exchanges, and our goal is to help property owners identify, execute, andmanage the right strategy to meet their specific objectives.

For additional information about how we can support wealth advisors and property owners during a 1031 exchange, please contact us.

1. https://www.irs.gov/pub/irs-drop/rp-02-22.pdf
2. http://www.dstproperties1031.com/dst-corner/revenue-procedure-2002-22
3. https://www.irs.gov/irb/2004-33_IRB/ar07.html
4. http://www.ccim.com/cire-magazine/articles/tic-tactic/
5. https://www.realized1031.com/blog/the-limitations-of-delaware-statutory-trusts-dst-in-1031-exchanges

Disclosures

The information contained herein is intended for informational purposes only and does not constitute legal, tax, or accounting advice or any other advice of any kind. Information contained herein relates to general market information and/or general firm business information and does not constitute an offer to sell or a solicitation of an offer to buy any security and may not be relied upon in connection with the purchase or sale of any security. If any offer of securities is made, it shall be made pursuant to a formal offering which will contain material information not contained herein and that will supersede, amend and supplement this information in its entirety.

*It is important to note that although 1031 exchanges may be appropriate for some, it may not be appropriate for others. Property owners should consult with their attorneys, tax counsel, financial advisors and other professionals regarding the applicability of 1031 exchanges to your current situation. *

This piece contains broad market commentary regarding a specific point in time, is subject to change without notice, and should not be considered blanket advice or advice of any kind – each property owners’ situation is different and should be evaluated on an individual basis prior to determining whether or not a 1031 exchange is appropriate. Certain of the economic and market information contained herein has been obtained from published sources and/or prepared by third parties. While such sources are believed to be reliable, Platform Ventures and its affiliates, employees and representatives do not assume any responsibility for the accuracy of such information and have no obligation to verify its accuracy.