Now that the recession appears to be fading into memory, Section 1031 Exchanges are on the rise. Section 1031 of the Federal Tax Code allows property owners to defer taxes by exchanging the sale property into one or more other real properties. Because the 1031 Exchange has a short time period in which to identify the replacement property (or properties) – 45 days – investors have often found themselves in a quandary in finding replacement property that meets their investment criteria.

Tenant-In-Common Investments

Historically, when one investor could not find an appropriate investment by themselves, they often considered a tenant-in-common investment. The tenant-in-common investment vehicle is basically the co-ownership of property between a number of investors who enter into either a co-ownership agreement, master lease agreement and/or management agreement along with other documents necessary to convey real estate to the tenants-in-common owners and manage the property.

The basic problem with tenant-in-common deals is that Internal Revenue Service (IRS) requirements mandate that certain fundamental decisions, such as selling or refinancing the property, entering into a lease agreement or a brokerage agreement must be agreed upon by all individual investors. From experience, an agreement where one individual investor has the right to block the will of the majority of the other investors can lead to disaster, particularly in times of declining valuations. In the past few years, a number of tenant-in-common deals were held up or “sabotaged” by individual investors trying to obtain a better position vis-à-vis the other investors. Many investors also balk at executing an individual environmental guaranty and a “bad boy” loan guaranty carve out.

Delaware Statutory Trust

In response to the need for a tenant-in-common type of investment – without the complications inherent in the tenants-in-common ownership structure – the Delaware legislature adopted an entity that has become known as a Delaware Statutory Trust.

The particulars of a Delaware Statutory Trust are as follows:

The Delaware Statutory Trust requires compliance with the requirements of the IRS Revenue Ruling 204 – 86. At a minimum, the Delaware Statutory Trust must be a special purpose entity, must be bankruptcy remote and structured in a fashion wherein the beneficiaries of the trust are not making decisions regarding the operation of the Trust’s real estate.

The IRS ruling also establishes prohibitions on the powers and activities of the trustees. These prohibitions have become known as the “seven deadly sins,” which include:

1. The trustee cannot renegotiate the terms of the existing mortgage loans nor can it obtain any new mortgage financing from any party except where the tenant is bankrupt or insolvent;
2. The trustee cannot enter into new leases or renegotiate existing leases except where a property tenant is bankrupt or insolvent;
3. Once the initial offering is closed, there can be no future capital contributions to the Delaware Statutory Trust by either current or future beneficiaries;
4. The trustee cannot reinvest the proceeds from the sale of the real estate;
5. The trustee is limited to making the following types of capital expenditures with respect to the property: (a) expenditures for normal repair and maintenance of the property; (b) expenditures for minor non-structural capital improvements of the property; and (c) expenditures for repairs or improvements required by law;
6. All cash, other than necessary reserves, must be distributed on a current basis; and
7. Any cash held by a Delaware Statutory Trust can only be invested in short term debt obligations.

Realistically, the only type of real estate that will work in the Delaware Statutory Trust are master lease transactions – so called triple net long-term leases to investment-grade tenants. The beneficiary’s only right in a Delaware Statutory Trust is the distribution of income. There are no rights in the operation or management of the property, as that is left to the trustee (who must be a Delaware resident or entity by statute). A “Delaware Trustee” is normally a professional real estate or investment company.

The main advantage of a Delaware Statutory Trust is that there is only one loan to the borrower, and individual beneficiaries of the trust do not have to be involved in the lending process. The Delaware Statutory Trust is the borrower on all financing property.

There is no limitation to the number of beneficiaries permitted under a Delaware Statutory Trust. Arguably a Delaware Statutory Trust may be able to allow its beneficiaries to do a tax-free exchange on their pro rata share of the Delaware Statutory Trust property when it is eventually sold.

The primary downside of a Delaware Statutory Trust is the lack of official IRS recognition and “acquiescence” in its use in a 1031 Exchange. While there are a large number of examples of Delaware Statutory Trusts being used in a 1031 Exchange, other than Revenue Ruling 2004 – 86 and certain private letter rulings, there is no IRS “good housekeeping seal of approval” for Delaware Statutory Trusts. However, most, but not all, real estate commentators are currently comfortable with the use of the Delaware Statutory Trust in a 1031 Exchange.

The legislation establishing the Delaware Statutory Trust has also contemplated what happens if the trust commits one of the “seven deadly sins” by providing that a Delaware Statutory Trust can convert to a limited liability company (LLC) upon pre-agreed terms. Fortunately, Delaware law treats the conversion as if the new LLC was the same legal entity as a Delaware Statutory Trust. Effectively the real estate is not being transferred, and the borrower on the loan remains the same. Other provisions, such as being a special purpose entity and bankruptcy remote, remain in place.

The obvious downside, however, is that once the trust converts to an LLC, the LLC will be treated as a partnership for federal income tax purposes, and the investors will not be able to do a subsequent tax-free exchange of their interest in the LLC. Some commentators have proposed that the LLC could reconvert to a Delaware Statutory Trust once the problem that caused the initial conversion is taken care of (i.e., the elimination of one of the “seven deadly sins”).

The main advantage of the Delaware Statutory Trust is that you can identify the trust’s real estate as one of the three replacement properties by the end of the 45-day identification period for a 1031 Exchange. The trust can serve as a backup if the preferred exchanges are unable to be consummated for any reason during the statutory period. In other words, the Delaware Statutory Trust can be an effective backstop in a 1031 Exchange.

Most Delaware Statutory Trusts are set up by real estate syndicators or private investment corporations. Traditionally, they purchase the same types of properties that net lease companies,such as National Realty Trust, are purchasing. Selection of the trustee and the management company can be particularly important, should the company that is leasing the net lease property get into financial trouble and is forced into bankruptcy (i.e., Kmart, Circuit City and Montgomery Ward). Some due diligence on the tenant and the particular property is required even though the beneficiary of a Delaware Statutory Trust has no management responsibilities or obligations.