What Are the Problems With a Delaware Statutory Trust?

A Delaware Statutory Trust, or DST, is a legal entity used to hold title to investment real estate. It is a common vehicle for investors seeking to defer capital gains taxes through a Section 1031 exchange, which allows for the reinvestment of proceeds from a sold property into a “like-kind” asset. The DST structure offers a passive ownership interest in professionally managed properties that might otherwise be inaccessible to an individual.

While the benefits are frequently highlighted, the framework that makes a DST eligible for tax deferral also imposes rigid constraints and introduces risks that are not always apparent at the outset.

Investor Control and Flexibility Limitations

A problem for investors in a DST is the lack of control over the investment and the operational inflexibility imposed on the trust manager, or sponsor. The IRS established strict guidelines in Revenue Ruling 2004-86 to ensure the trust qualifies for a 1031 exchange. These rules, sometimes called the “seven deadly sins,” make the trust a passive holder of real estate, which limits the sponsor’s ability to react to changing market conditions.

One restrictive rule is the prohibition on future capital contributions after the offering is closed. If the property requires an unexpected repair, such as a roof replacement not covered by existing reserves, the sponsor cannot call for additional capital from investors. This inability to raise new funds can put the property in a precarious financial position, potentially leading to deferred maintenance or foreclosure.

The trustee is also forbidden from renegotiating the terms of existing loans or acquiring new financing. This is a handicap if interest rates fall, as the trust cannot refinance to reduce debt payments and improve cash flow. It also poses a problem if a tenant declares bankruptcy, as the trustee cannot seek new financing to cover operational shortfalls or fund improvements needed to attract a replacement.

Furthermore, the sponsor cannot enter into new leases or renegotiate existing ones, except in limited situations like a tenant’s bankruptcy. To work around this, many DSTs use a “master lease” structure where the property is leased to a single entity that can then sublease to tenants. This structure introduces its own complexities and dependencies.

Significant Fees and Financial Drag

The financial return from a DST is diminished by a multi-layered fee structure that creates a drag on performance. These costs are detailed in the Private Placement Memorandum (PPM) and are built into the deal, reducing the net income distributed to investors and the potential for appreciation. Common fees include:

• Upfront acquisition fees paid to the sponsor for sourcing, analyzing, and purchasing the property.
• Organizational and offering expenses that cover the legal and administrative work of structuring the trust.
• Sales commissions, often ranging from 6% to 9%, paid to the brokerage firms that place investors into the DST.
• Ongoing asset management fees paid to the sponsor for their oversight of the property and the trust.
• Property management fees charged for the day-to-day operations of the real estate, such as rent collection.
• A back-end disposition fee charged by the sponsor upon the sale of the property.

The combination of these fees means that the underlying property must perform exceptionally well for the investor to achieve a market-rate return.

Sponsor and Underlying Asset Risks

An investment in a DST is an investment in the sponsor managing it and the specific real estate it holds. The success or failure of the venture depends on the sponsor’s competence and financial stability. Investors delegate all management authority, placing trust in the sponsor to execute their business plan and act as a responsible fiduciary.

A sponsor with a poor track record or insufficient financial resources can lead to mismanagement and reduced distributions. Because DSTs are private placements, there is less public information available compared to publicly traded companies, making due diligence more challenging. An investor must carefully review the sponsor’s history and the performance of their previous offerings.

Beyond the sponsor, investors are exposed to the inherent risks of the underlying real estate. These include market risks, where a downturn in the economy can reduce property values, and tenant risk, where the vacancy of a key tenant can severely impact income. Unexpected capital expenditures and property-specific issues add another layer of uncertainty.

This structure also creates concentration risk. Many investors roll a large amount of capital from the sale of a single property into one DST. This means their investment is tied to a single property or a small portfolio managed by one sponsor, often in a specific geographic area. This lack of diversification can magnify losses if that particular asset class or region performs poorly.

Exit and Liquidity Challenges

A primary problem with DST investments is their lack of liquidity, as there is no established public secondary market for these interests. An investor who needs to access their capital before the sponsor sells the property will find it difficult to find a buyer. The holding period is often projected to be between five and ten years, but the sponsor has sole discretion over the timing of the sale.

The sponsor may choose to hold the property for longer than anticipated if market conditions are unfavorable, trapping an investor’s capital for an extended period. This illiquidity makes DSTs unsuitable for anyone who might need to access their funds for emergencies or other life events.

While some sponsors may attempt to facilitate a private sale, this is not guaranteed. Finding a buyer is challenging, and the seller would likely have to offer the interest at a discount. Such a sale would also be a taxable event, potentially negating the tax-deferral benefits the investor originally sought.

When the property is sold, the investor faces another decision. They can either pay capital gains and depreciation recapture taxes on their share of the proceeds or they must initiate another 1031 exchange. This forces the investor back into a time-sensitive search for a new replacement property, perpetuating a cycle of tax deferral without achieving true liquidity.