DST Like-Kind Qualification: Do Delaware Statutory Trust Interests Qualify in a 1031?

Rev. Rul. 2004-86 treats a restricted DST owner as owning a slice of the building, not a trust certificate

The ruling analysed a trust holding one net-leased property, Blackacre, bought with a ten-year nonrecourse loan, and asked whether two investors could swap their own properties for all of the trust's interests through a qualified intermediary. It said yes, on two grounds that every DST offering still relies on.

First, the trust is an investment trust under Reg. §301.7701-4(c)(1) because the trustee has no power to vary the investment of the certificate holders, so it is classified as a trust rather than a business entity. Second, each owner is entitled to the income of their fractional share, which makes them the owner of that share under §677, and the ruling applies the settled principle that the owner of an undivided fractional interest of a trust is considered to own the trust assets attributable to it.

In the ruling's own words, the transaction 'is the exchange of real property for an interest in Blackacre, and not the exchange of real property for a certificate of trust or beneficial interest.' That sentence is the entire legal basis for identifying and receiving a DST interest as replacement property.

The 2020 regulations still exclude 'certificates of trust or beneficial interests', so grantor-trust status carries the whole result

Reg. §1.1031(a)-3(a)(5)(i), effective for exchanges beginning after December 2, 2020, lists the intangibles that count as real property, including fee ownership, co-ownership, leaseholds, easements and options, and then names what never counts regardless of state law: stock, partnership interests other than a §761(a) electing partnership, and certificates of trust or beneficial interests.

Read in isolation that exclusion looks fatal for a DST. It is not, because the grantor-trust look-through means you are treated as acquiring the real estate itself, never the certificate. The preamble to the final regulations (TD 9935) says so: nothing in the regulations or the 2017 tax act 'is contrary to the view that a transfer of an interest in a DST, if a grantor trust, is treated as the transfer of the underlying property held by the DST.'

Two consequences follow. A DST holding U.S. real estate is like-kind to whatever U.S. investment real estate you sold, since §1031(h) is the only remaining like-kind boundary for real property. And the trust must actually be a grantor trust on the day you acquire your interest, which depends on nothing but the trust agreement.

Seven trustee restrictions in the ruling are the checklist your attorney should tick off in the trust agreement

The ruling describes a trustee whose activities are limited to the collection and distribution of income, with a short list of things it may never do. The trust agreement of any offering you consider should carry the same limits; sponsors and their counsel call them the seven deadly sins.

Two further facts in the ruling matter for structure: interests are of a single class representing undivided beneficial interests, and each owner has the right to an in-kind distribution of their proportionate share of trust property. A second class with different economics would push the trust toward business-entity classification under §301.7701-4(c)(1).

• No additional contributions of assets or money to the trust after the offering.
• No renegotiation of the terms of the debt used to acquire the property, and no new borrowing.
• No renegotiation of the existing lease and no leases to other tenants, except on the tenant's bankruptcy or insolvency.
• No reinvestment: the trustee may not exchange the property for other property or buy anything except the permitted short-term investments.
• Only minor non-structural modifications to the property unless the law requires more.
• Cash between distributions and all reserves invested only in short-term U.S. government obligations or bank certificates of deposit maturing before the next distribution date.
• All available cash less reserves distributed to owners in proportion to their interests, quarterly in the ruling's facts.

If the trustee can sell and rebuy, re-lease or refinance, the trust is a partnership and the interest is not like-kind

The ruling spells out the failure case. If the trustee may dispose of the property and acquire new property, renegotiate the lease or lease to other tenants, renegotiate or refinance the loan, invest cash to profit from market fluctuations, or make more than minor non-structural modifications, the trust 'will be a business entity which, if it has two or more owners, will be classified as a partnership for federal tax purposes.'

A partnership interest is expressly outside the real property definition, and the ruling shuts the usual escape hatch: because the owners do not hold the assets as co-owners under state law, the trust cannot make a §761(a) election to be excluded from subchapter K. There is no partial credit; the interest is either real estate or a partnership interest.

Red flags in a private placement memorandum include a trust agreement the trustee can amend to loosen the restrictions, a plan to add properties after closing, a value-add or development business plan, and an operating business such as a hotel or care facility run inside the trust rather than through a master lease. What happens if the trust converts to an LLC in a workout is covered under sponsor or master-tenant bankruptcy.

Documenting the exchange on Form 8824: describe the real estate, file for the year of sale, attach a statement for several trusts

Form 8824 Part I asks for a description of the like-kind property given up on line 1 and received on line 2, and the form notes that only real property should be described on those lines. Describe the DST interest by the trust's name, the property's street address and the percentage interest acquired, so the return itself shows real estate rather than a security.

File the form with the return for the tax year you transferred the relinquished property, even when the trust closed in the following January. If you bought into more than one trust, the instructions allow a summary Form 8824 with an attached statement giving the full information for each exchange.

Keep the trust agreement, the PPM's tax discussion and the closing statement with the return, and have your CPA or attorney confirm the treatment before it is filed. If the offering documents do not state that the trust agreement follows Rev. Rul. 2004-86, ask why before your 45-day identification deadline closes.

What the ruling does not decide: your holding purpose, your deadlines and the value you actually receive

The holding is conditioned on 'the other requirements of §1031' being satisfied. The ruling says nothing about whether you held the relinquished property for investment, whether you identified within 45 days and closed within 180, or whether the same taxpayer sold and bought; those tests live in the eligibility rules and the deadline rules.

It also says nothing about economics. Like-kind status does not mean the interest is worth what you paid: offering costs and sales commissions come off the top, the interest has no public market for the trust's five-to-ten-year life, and the trustee, not you, decides when the property sells. DST fees and loads and illiquidity deserve as much attention as the tax analysis.

Breakwater Exchange is a 1031 exchange broker with more than 20 years of experience and over a billion dollars of DST transactions, working with vetted national sponsors whose trust agreements are written to the ruling. We can show you where those restrictions appear in a specific offering's documents.