THE SEVEN DEADLY SINS

In Delaware Statutory Trusts (DSTs), the Internal Revenue Ruling 2004-86 outlines crucial regulations known as the “seven deadly “sins.” These rules are designed to limit the DST trustee’s powers, providing additional protection and benefits to the beneficiaries. By adhering to these regulations, trustees ensure proper fund distribution and mitigate unnecessary risks with the DST’s assets. DST’ss explore seven deadly sins and understand how they safeguard your investments.

1. Thou Shalt Not Accept More Contributions Once the DST Offering is Closed

Once a trustee closes an offering, it must remain closed. At the outset, investors purchased a proportional share of the DST’s beneficial interest. Accepting more contributions after closure would dilute the DST’s ownership, which would be unfair to the initial investors. For this reason, new contributions to a closed DST are disallowed. 

2. Thou Shalt Not Take On More Debt or Restructure the Existing Debt

Investors have a right to understand and evaluate the debt structure before investing in a DST as part of their risk assessment for an illiquid investment. If the trustee was allowed to renegotiate the current debt or take out or assume new debt after that investment was made, it would be unfair to the investors. 

3. Thou Shalt Not Reinvest the Proceeds of the Sale of Property in the DST

All proceeds of a DST sale must be distributed to the investors so that they can decide what to do with it. The investor can pay taxes or do another 1031 exchange upon sale. The trustee cannot make that choice for them by reinvesting the funds in new real estate.

4. Thou Shalt Not Make Prohibited Capital Expenditures

Trustees of a DST cannot just make any capital expenditure they see fit. The rules require that the trustee only make capital expenditures on:

• Normal repairs and maintenance
• Minor non-structural capital improvements
• Those required by law

More major, wall-moving-type structural changes could greatly increase the risk profile of an offering.

5. Thou Shalt Not Invest Proceeds of the DST in Disallowed Investment Vehicles

After a DST closes, there may be an interim pause before monthly distribution checks. The trustee may be tempted to invest the cash proceeds in another investment vehicle to keep the money working for the investors. Still, the trustee is also restricted in how (s)he can invest those proceeds. In the interim, between monthly distribution checks to investors, the trustee can only invest the proceeds in short-term debt obligations that can be converted to cash quickly

6. Thou Shalt Not Withhold Cash Beyond Necessary Reserves

The trustee cannot withhold funds from the DST investors outside of reasonable reserves for necessary repairs and emergencies. All other cash receipts must be distributed to the investors in a reasonable amount of time.

7. Thou Shalt Not Enter Into New Leases or Renegotiate Current Leases

The trustee may not enter into new leases or renegotiate current leases during a DST’s holding period. A master lease structure is used to work around this rule. This structure places the trustee between the property renters and the investors. The trustee’s job is to maximize rents, minimize costs, and follow the rules of the Master Lease to pay investors in a timely manner.

In asset classes with shorter-term tenants (like multifamily or self-storage), master leases are often structured with “bonus” rent potential. This bonus rent split may be as high as 90% to the investors and 10% to the sponsor. Bonus rents align interests because the sponsor and investor participate when the underlying property outperforms financial projections.

The seven deadly sins outlined in Internal Revenue Ruling 2004-86 are essential for maintaining the integrity and stability of DST investments. By imposing these restrictions, the IRS ensures that DST trustees act in the best interests of the beneficiaries, providing a level of protection and predictability crucial for conservative real estate investors. Understanding these regulations can help you appreciate the safeguards to protect your investments and make informed decisions when considering DSTs as part of your investment strategy.