Hotel and Hospitality DSTs: Why Few Exist and How They Are Structured

A hotel sells rooms by the night, and the ruling's trustee can only collect a fixed rent

The trust in Rev. Rul. 2004-86 owns one net-leased building. Its tenant pays a rent that is a fixed amount, adjustable only by a formula tied to a fixed rate or an objective index such as the Consumer Price Index, and the ruling states that the rent is not contingent on the tenant's ability to lease the property or on its gross sales or net profits. The trustee's activities are limited to the collection and distribution of income; it may not renegotiate the lease, enter leases with anyone else except on the tenant's bankruptcy or insolvency, and may make only minor non-structural modifications to the building.

A hotel is the opposite of that building. A filed lodging REIT 10-K defines its business by occupancy, average daily rate and revenue per available room, and notes that changes in rate have a more pronounced effect on revenue than changes in occupancy. Every one of those numbers is set by an operator making daily pricing decisions. If the trustee made them, the trust would hold the powers that the ruling says turn an investment trust into a business entity taxed as a partnership, and the interests would stop being real property for your exchange, the point explained at DST like-kind qualification.

So a hospitality DST cannot run the hotel. It can only own the real estate and lease the entire operation to someone else at a rent the trust does not adjust. That single fact is why the sector sits at the edge of the DST market rather than at its centre, alongside the other operating-heavy classes compared at DST asset classes.

The REIT rules solved the same problem the same way: a lessee holds the lease and an independent operator runs the hotel

Real estate investment trusts live under a similar restriction, and the Code shows the accepted workaround. Under section 856(d)(8)(B), rent from a taxable REIT subsidiary counts as qualifying rent for a qualified lodging facility only if the property is operated on behalf of that subsidiary by an eligible independent contractor, defined in section 856(d)(9) as a contractor actively engaged in operating lodging facilities for unrelated parties. The statute defines a lodging facility as a hotel, motel or other establishment more than one-half of whose dwelling units are used on a transient basis.

The filed lodging REIT 10-K describes the result in one sentence: in order to continue to qualify as a REIT, independent third parties must operate its hotels, so it leases substantially all of them to subsidiary lessees that engage third-party managers under management agreements. Those agreements carry initial terms of 5 to 30 years, base fees of roughly 1% to 4% of gross hotel revenues plus incentive fees, and franchise royalties of 5% to 6% of gross rooms revenue where a brand is involved.

A hotel DST borrows that layering. The trust is the REIT's role, the master tenant is the lessee, and a hotel management company sits under the master tenant. The ruling adds one more condition the REIT rules do not: the tenant must not be related to the investors or the trustee. How a master lease moves risk from the building to the tenant is set out at DST master lease risk.

The master tenant carries the operating risk, so the guaranty and the furniture reserve decide whether the fixed rent is real

A filed 10-K of a non-traded REIT that sells DST interests describes the master tenant's position plainly: it is responsible for subleasing the property and bears the risk that the underlying cash flow from the property and all capital expenditures may be less than the master lease payments, and the filing adds that there can be no assurance the parent can or will fulfil its guaranty obligations. A filed REIT prospectus from another program describes a demand note between the parent and the master tenant, with the master tenant holding limited rights to defer rent when operating cash falls short.

Hotels make that risk larger than in any other class, because they consume capital continuously. The lodging REIT's agreements generally require it to fund 4% of hotel revenues into a reserve for furniture, fixtures and equipment, and brand standards govern signage, furniture and guest services. Under the ruling the trustee cannot accept additional contributions and cannot make more than minor non-structural changes, so a renovation demanded by a brand has to come from reserves set at closing or from the master tenant's own pocket, the problem worked through at how a DST pays for repairs.

If room revenue falls below the fixed rent, your distribution depends on the master tenant's deferral rights and then on its guarantor. Distributions in any DST can be reduced or stopped, and a hospitality trust adds nightly pricing, seasonality and brand capital to the usual causes described at when DST distributions are cut.

Only the land and building are like-kind; the furniture, the brand and the business are not

Since 2018, section 1031(a)(1) applies only to real property. Reg. section 1.1031(a)-3 lists hotels and motels among the buildings that are inherently permanent structures, and treats central air conditioning and heating systems, elevators, fire suppression systems and similar items as structural components that are real property. Example 12 of the same regulation holds that a licence to operate a business in a building is not real property, because it is a right to run the business rather than a right to use the building.

Furniture, fixtures and equipment are personal property under section 1245(a)(3), which carves buildings and their structural components out of its scope. Reg. section 1.1031(k)-1 lets personal property that is incidental to real property, meaning typically transferred with it and worth no more than 15 percent of it, be disregarded for the identification rules and the intermediary safe harbor. That keeps the exchange from collapsing, but it does not make the furniture like-kind: its value is still other property under section 1031(b), the boot mechanics covered at furniture and boot in a 1031 exchange.

Depreciation follows the same line. Section 168(e)(2)(A) excludes from dwelling units any unit in a hotel, motel or other establishment more than one-half of whose units are used on a transient basis, so a hotel building is 39-year nonresidential property rather than 27.5-year residential property.

What a hotel seller should do instead of waiting for a hospitality DST

Separate the sale into its parts before contract. The real property proceeds are what your exchange can shelter; the furniture, equipment and business value are taxed on their own, with depreciation on the personal property recaptured as ordinary income under section 1245. The allocation questions specific to selling a hotel are at 1031 exchange of a hotel or motel.

Then place the real property proceeds where the structure and the asset agree. Single-tenant and portfolio trusts built around long fixed leases are described at single-tenant vs portfolio DSTs; the operating classes that use a master lease carry the risks this page describes in a milder form. If a sponsor does offer a hospitality trust, read the tax opinion on the rent formula, the guarantor's financial statements and the furniture reserve before anything else.