IRS Revenue Ruling 2004-86, which forms the basis for a DST transaction in a Section 1031 exchange program, has prohibitions on the powers of the trustee, in order for a beneficiary to be treated as acquiring a direct interest in real estate for tax purposes. These restrictions are built into the trust agreement.
Because of these IRS restrictions, the only forms of real estate ownership transactions that will work in a DST are a master lease transaction, whereby the master tenant takes on all of the operating responsibilities, or a triple net long-term lease to an “A” credit tenant. The sponsor will also attempt to mitigate against the effect of these seven prohibitions by:
The solution to give the lender comfort against the DST’s inability to act if the loan is endangered is to place an operative provision in the trust agreement providing that if the trustee determines that the DST is in danger of losing the mortgaged property due to an actual or imminent default on the loan, and tax-related restrictions are preventing the trustee’s ability to act, (the seven prohibitions), Delaware law permits conversion by what is basically a simple election which does not constitute a transfer under Delaware law. This “springing LLC” will contain the same SPE and bankruptcy remoteness provisions as the DST (for the lender’s benefit), but it will permit the raising of additional funds, the raising of new financing or renegotiation of the terms of the existing financing, and the renegotiation of leases. In addition, it will provide that the trustee (or sponsor) will become the manager of the LLC with full operating control.
A DST borrower with a master tenant owned and controlled by a quality sponsor should be an attractive borrower for a lender, and various financing sources have embraced the DST structure. A steady market has been developing for DSTs because they are much less complex than the structure of a typical TIC transaction, they shield investors from liabilities with respect to the mortgaged property, and they remove the investors from involvement in operation of the property.