DSTs for Trustees: Prudent Investor Duties and Fractional Real Estate

The prudent investor rule judges the DST inside the whole trust portfolio, and tax deferral counts

California's Probate Code section 16047 requires a trustee to invest as a prudent investor would, considering the trust's purposes, terms and distribution requirements, and to evaluate each asset not in isolation but as part of an overall strategy. Its list of relevant circumstances includes the expected tax consequences of investment decisions, expected total return from income and appreciation, and needs for liquidity, regularity of income and preservation of capital. Delaware's 12 Del. C. section 3302 uses a prudent person standard that likewise lists anticipated tax consequences and authorizes every kind of property.

So deferring a large gain is a legitimate reason to exchange rather than sell, but it is one factor among several. Before relying on the statute, read the trust instrument: under section 16046(b) the settlor may expand or restrict the rule, and a trustee who relies in good faith on those express terms is protected. Who signs the exchange, the grantor or the trust, depends on the trust's tax status, covered at trust-owned real estate and 1031 strategies.

Diversification is a duty, and a single rental usually fails it before any DST enters the picture

Section 16048 imposes a duty to diversify unless, under the circumstances, it is prudent not to. A trust whose main asset is one building is concentrated in one tenant base, one market and one roof. Exchanging into several DSTs across sectors and sponsors spreads that risk while keeping the deferral.

Each DST, though, is a fixed basket: Rev. Rul. 2004-86 bars the trustee from buying new property or reinvesting sale proceeds, so one trust adds no diversification after it closes. Spreading across trusts, and the paperwork that comes with each, is covered at DST diversification levels.

Buying a DST delegates management, so document how you chose the sponsor and how you will monitor it

Section 16052 allows a trustee to delegate investment and management functions, but requires prudence in selecting the agent, setting the scope of the delegation and periodically reviewing the agent's performance. A trustee who does that is not liable for the agent's decisions. A DST is an extreme delegation: in a filed trust agreement the manager runs the trust exclusively, decides when to sell, and owes only the duties the agreement expressly sets out, which Delaware's Statutory Trust Act section 3806(c) allows the governing instrument to restrict, short of the implied covenant of good faith and fair dealing.

That makes the file important. Section 16047(d) requires a reasonable effort to ascertain the relevant facts, and section 16050 permits only costs that are appropriate and reasonable in relation to the assets and strategy. Keep the memorandum, the comparison of offerings, the fee figures in dollars and your reasons, and review the sponsor's annual reports each year; a working list is at DST offering due diligence checklist, and the fee stack at DST fees and loads.

Income beneficiaries and remainder beneficiaries want different things from the same trust

California's section 16003 requires a trustee of a trust with two or more beneficiaries to act impartially in investing, taking their differing interests into account. A surviving spouse entitled to income cares about the size and regularity of distributions; children who take the remainder care about what is left and when it can be sold.

A DST pays out available cash after fees and reserves, monthly or quarterly depending on the agreement, which suits an income beneficiary only while the tenant pays; distributions are not assured and can stop if the master tenant defaults. The remainder beneficiaries face the opposite issue: the trust cannot choose when the property sells, so a termination date or mandatory distribution can arrive before the DST does. If the trust must end on a fixed date, check the sponsor's stated hold against it; see DST illiquidity and exits.

Hypothetical: a trust holds a $2,000,000 building with a $400,000 basis, pays income to a spouse and ends at the spouse's death. Exchanging into four DSTs keeps the $1,600,000 gain deferred and replaces rent the trustee had to collect with distributions the trustee only monitors, but at termination the trustee may have to distribute DST interests in kind rather than cash. Run your own numbers with your CPA and counsel.

The trust itself must qualify to buy, and the paperwork goes in the trustee's name

DSTs are sold to accredited investors. Under Rule 501(a)(7) a trust qualifies with total assets above $5,000,000, not formed to buy the securities, and directed by a sophisticated person; Rule 501(a)(8) covers entities whose equity owners are all accredited. Revocable trusts and other routes are covered at DST accredited investor rules.

When the trust later receives distributions in kind or divides at termination, the transfer runs through the sponsor's procedures described at transferring DST interests to heirs and trusts.