DSTs for First-Time Passive Investors: Landlords Stepping Back

You keep tax-deferred ownership of real estate, reported on your own return

Rev. Rul. 2004-86 holds that a Delaware statutory trust whose trustee is limited to collecting and distributing income is an investment trust under Reg. section 301.7701-4(c), and that each owner of an undivided fractional interest is treated as owning that share of the real estate. That is why the exchange into the trust is an exchange of real property for real property under section 1031, rather than for a beneficial interest in a trust, which Reg. section 1.1031(a)-3(a)(5) treats as not real property.

Because the trust is a grantor trust owned by many people, Reg. section 1.671-4(b)(3) requires the trustee to give each owner a statement of the income, deductions and credits attributable to that owner's portion. You carry those figures onto your return the way you carried your old rental's books, except that somebody else keeps the books. DST tax return reporting walks through the forms.

Your basis carries over too. Under section 1031(d) the basis of the replacement interest is the basis of what you gave up, adjusted for boot and debt, so the depreciation schedule you had left continues inside the trust. Depreciation inside a DST covers how it runs.

You give up every decision the trust agreement reserves to the manager

A filed form of DST trust agreement states that Class 1 beneficial owners 'shall not have the right or power to direct in any manner the Trust or the Manager' and lists what they cannot do: contribute additional assets, be involved in operation or management, cause the trust to negotiate loans or leases, or cause it to sell assets and reinvest the proceeds (form of trust agreement, section 6.13).

Those limits are the price of the tax ruling, not a sponsor's preference. Rev. Rul. 2004-86 says that if the trustee could dispose of the property and buy new property, renegotiate the lease or the loan, invest cash to profit from market swings, or make more than minor non-structural modifications, the trust would be a business entity taxed as a partnership and the exchange would fail. The seven deadly sins and who controls a DST give the detail.

For a landlord used to approving every repair, the practical change is that there is nothing to approve. Under a filed form of master lease the master tenant pays taxes, insurance, maintenance and utilities and may sublease without the landlord's consent; the trust's only business is to hold the property and collect the rent.

Income arrives as a distribution, not as rent you collect

In the filed forms the trust leases the whole property to a sponsor-controlled master tenant for a fixed rent that is 'absolutely net' to the landlord; the master tenant keeps what the sub-tenants pay above that rent and bears the shortfall if they pay less (form of master lease, paragraphs 2.A and 2.D). One program backs the master tenant with an 'absolute and unconditional' guaranty from the sponsor's operating partnership; other programs may not.

The trust then distributes available cash after paying the manager's and Delaware trustee's fees and holding back the reserves the manager thinks necessary. One filed trust agreement pays monthly beginning the month after the property is acquired, after fees, reserves and debt service; another pays quarterly. The manager's fee in one form is 1% of gross rents payable under the master lease, paid monthly in arrears.

None of this is assured. Rent depends on the master tenant's ability to pay, the master tenant depends on the sub-tenants, and the manager can enlarge reserves or hold back distributions. Distribution timing and reliability and master lease risk explain how income can fall or stop.

The clauses that catch first-time passive owners off guard

Each of these is in the filed forms, and no single investor can negotiate them out. Read them before the subscription package, not after.

• No market: the beneficial interests 'shall be non-transferable' except as the agreement permits, and a third-party offer triggers the depositor's right of first refusal, ten business days in one form and thirty days in another. Illiquidity and exits shows what a resale looks like in practice.
• No new money in either direction: the trust cannot accept capital from an owner, so there are no capital calls, but there is also no way to fund a problem with fresh equity. Repairs and reserves without new capital explains what happens instead.
• The sale date is not yours: 'The Manager may sell the Trust Estate at any time,' and that sale starts a new 45-day clock for you. Selling a DST and the next 1031 covers the decision.
• A rescue changes your tax position: if the master tenant stops paying or files for bankruptcy, the manager may move the property into a limited partnership or LLC and hand you units instead of a trust interest. The springing LLC explains the consequences.
• Your losses stay passive: rental activity is passive under section 469(c)(2), and losses carried from the old rental follow the rules on DST passive losses and sale.

The suitability review decides whether a passive trust fits you at all

A DST interest is a security sold under Regulation D, so the broker-dealer placing you must follow Regulation Best Interest. It requires a reasonable basis to believe the recommendation is in your best interest given your investment profile: age, other investments, financial situation and needs, tax status, objectives, experience, time horizon, liquidity needs and risk tolerance.

Expect to answer, in writing, how much of your net worth the trust would represent, when you will next need the money and what you will do if distributions stop. How much net worth belongs in DSTs is a fair starting point. You must also meet the accredited investor tests in Rule 501(a), which the accreditation page explains.

A first-year plan for a new passive owner

Set the year up before the first distribution arrives.

• File Form 8824 with the return for the year you sold; line 6 asks for the date you received the trust interest, which the sponsor's closing confirmation supplies (Form 8824 instructions).
• Ask the sponsor when the trustee's statement under Reg. section 1.671-4 will arrive each year and whether it breaks income out by state before you commit to a filing date.
• Open nonresident state returns where the trust's property sits; multi-state tax issues lists the mechanics.
• Keep the memorandum, the signed trust agreement, the closing statement and each year's statement in one file; the records an audit asks for explains why.
• Reread the distribution and reserve clauses before judging the first few payments; the agreement, not the marketing sheet, sets what you are owed.