How Can a Taxpayer Exchange Investment Real Estate in a Tax Deferred…

How Can a Taxpayer Exchange Investment Real Estate in a Tax Deferred Like Kind Exchange for an Interest in a Delaware Statutory Trust?

Preamble to a Section 1031 Like-Kind Exchange

Under Section 1031(a) of the U.S. Internal Revenue Code (Code), no gain or loss is recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment. This type of tax non-recognition transaction is also referred to as a like-kind exchange or a tax-deferred exchange, and among the other requirements that must be satisfied to be entitled to non-recognition treatment, addressed in my article “Nuts and Bolts of a Section 1031 Like-Kind Exchange”, the properties exchanged must be of “like kind.” Section 1031 provides that like kind property does not include, among other things, property constituting inventory, stocks, bonds or notes, interests in partnerships, or certificates of trust or beneficial interests.

The Treasury Regulations channel “like kind” property by reference to its nature or character and not as to its grade or quality. One kind or class of property may not be exchanged under section 1031 for property of a different class. For example, a taxpayer who is not a dealer in real estate (i.e., its holding of same not being “inventory”) exchanges city real estate for a ranch or farm or exchanges improved real estate for unimproved real estate, recognizes no gain or loss on such exchanges, those kinds or classes being deemed the same for purposes of this tax statute.

So, then, how does a taxpayer who is not a dealer in real estate exchange city property or a ranch, or improved or unimproved real estate for an interest in a Delaware statutory trust (DST) and have that replacement interest in the DST be deemed property of a like-kind? The answer, noted below, is the offspring of a mating of Delaware state law and applicable U.S. tax law.

What is a Delaware Statutory Trust?

Delaware law provides that a Delaware statutory trust is an unincorporated association recognized as an entity separate from its owners. A Delaware statutory trust is created by executing a governing instrument (e.g., a Declaration of Trust or a Trust Deed) and filing an executed certificate of trust with the Delaware Secretary of State. Creditors of the beneficial owners of a Delaware statutory trust may not assert claims directly against the property in the trust. A Delaware statutory trust may sue or be sued, and property held in a Delaware statutory trust is subject to attachment or execution as if the trust were a corporation (i.e. as if the trust was an individual for purposes of Delaware attachment law). Beneficial owners of a Delaware statutory trust are entitled to the same limitation on personal liability because of actions of the Delaware statutory trust that is extended to stockholders of Delaware corporations.

How is an Interest in a Delaware Statutory Trust “Like Kind” Property?

A series of entity classification rules specified in IRS Treasury Regulations (Regs) and an instructive IRS Revenue Ruling provide the framework and sample fact hypothetical (set forth at the end of this article) to enable DST promoters, or taxpayers seeking the tax benefit of §1031, to properly organize a Delaware statutory trust and tailor its governing instrument to enable lawful deferral of otherwise applicable unrealized taxable gain on disposition of investment real property.  The following sections of the Regs provide the roadmap to the desired tax-neutral outcome and the reconciling rationale why.

  1. Section 301-7701-2(a) defines a “business entity” as any entity recognized for Federal tax purposes (including an entity with a single owner that may be disregarded as an entity separate from its owner under §301.7701-3) that is not properly classified as a trust under §301.7701-4 or otherwise subject to special treatment under the Code.
  2. Section 301-7701-4(a) provides, generally, that an arrangement is treated as a trust if the purpose of the arrangement is to vest in trustees responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of this responsibility and, therefore, are not associates in a joint enterprise for the conduct of business for profit.
  3. Under §677 (a) of the Code, the grantor of a trust is treated as the owner of any portion of a trust whose income, without the approval or consent of any adverse party is, or, in the discretion of the grantor or a non-adverse party, or both, may be distributed, held, or accumulated for future distribution to the grantor or the grantor’s spouse.
  4. A person that is treated as the owner of an undivided fractional interest of a trust under subpart E of part I, subchapter J of chapter 1 of the Code (§671 and following), is considered to own the trust assets attributable to that undivided fractional interest of the trust for Federal income tax purposes.

Accordingly, assuming the structure and operation of a DST consistent with IRS Revenue Ruling 2004-86, 2004-2 C.B. 191, factual hypothetical repeated below, a DST formed to hold real property subject to a lease (typically a single new or recently rehabilitated commercial property) under the DST’s governing instrument tailored consistently with the elements described in that Ruling, is an arrangement that would be classified as a trust for Federal tax purposes under §301-7701-4(c). Each of the trust’s owners would be treated, therefore, by application of Code section 677, as an owner of a pro-rata portion of the DST. Because an owner of an undivided fractional interest in a trust owns for Federal tax purposes the assets of the trust attributable to that interest, each owner would be considered to own for those purposes an undivided fractional interest in any real property held by the DST. Accordingly, under §1031 of the Code, a taxpayer may exchange an interest in real property for an interest in a compliantly-structured DST without recognition of gain or loss, assuming the satisfaction of the other requirements of §1031, including that the property held by the trust has the character of property being of a like-kind to the taxpayer’s relinquished property.

The So-Called “Seven Deadly Sins”

The following are the predicates for inclusion in the governing instrument of a Delaware statutory trust and its compliance in their discharge, and conduct expressly prohibited, to enable compliance by a DST/its promoters with the prescription of Revenue Ruling 2004-86, to entitle exchanging taxpayer investor-candidates, in transactions otherwise satisfying the requirements of section 1031, to lawfully exchange their built-in gain like-kind real property interests for interests in the DST, and avoid current income tax recognition on the inherent gains realized in connection with such transactions:

* No new capital can be raised by the DST after its initial capitalization;

* All cash must be distributed on a current basis with identical distribution rights in accordance with the trust;

*The DST cannot redevelop property or make capital repairs except for (a) normal repair and maintenance, (b) minor non-structural capital improvements and (c) those required by law;

* The DST cannot enter into new leases or renegotiate current leases (except in the cast of a tenant bankruptcy or insolvency);

* The DST cannot renegotiate the terms of existing loans or borrow new funds (unless a loan default exists as a result of a tenant bankruptcy or insolvency);

* The DST cannot reinvest sales proceeds of trust assets in any replacement asset; and

* The DST can only invest reserves and cash in short term Treasury or other obligations having maturity dates ripening prior to the next distribution date of the trust.

Compliant Delaware Statutory Trust Structure Facts Per Rev. Rul. 2004-86:

Individual A borrows money from bank Z and signs a 10-year note bearing adequate stated interest. On the same day, A uses the proceeds of the loan to purchase Blackacre, rental real property. The note is secured by Blackacre and is nonrecourse as to A. Immediately after this purchase, A enters into a net lease of Blackacre by a tenant (Tenant) for a term of 10 years.

Under the terms of the lease, Tenant must pay all taxes, assessments, fees, or other charges imposed on Blackacre by federal, state, or local authorities. Additionally, Tenant must pay all insurance, maintenance, ordinary repairs, and utilities relating to Blackacre. Tenant may sublease Blackacre. Tenant’s rent is fixed. The revenue ruling indicates that Tenant’s rent qualifies as fixed even if the lease agreement includes automatic periodic adjustments to the rent that are based on a fixed rate or on an objective index, such as an escalator clause based on the consumer price index. No adjustments are within the control of any of the parties of the lease. The amount of rent is not contingent on Tenant’s ability to lease Blackacre, on the Tenant’s gross sales, or on net profits derived from Blackacre.

On the same day that the lease was executed, A forms Trust and contributes Blackacre to Trust. Upon the transfer of Blackacre, Trust assumes the rights and obligations of A as to the note with Z and the lease with Tenant.

The terms of Trust provide for the following—

  • A single class of trust interests, each representing an undivided interest in the assets of Trust (in this case, Blackacre, which is subject to both the lease and the note);
  • Authorization for the trustee to establish a reasonable reserve for expenses that are associated with Trust’s holding Blackacre and that are payable out of trust funds;
  • Required quarterly distributions of all available cash, less reserves, to each beneficial owner of Trust in proportion to that owner’s relative interest in Trust;
  • The right of each beneficial owner to an in-kind distribution of that owner’s proportionate share of trust property;
  • A requirement that Trust invest all cash that it holds in either—

(a) Short term obligations of (or guaranteed by) the United States, or any agency or instrumentality thereof; or

(b) Certificates of deposit of a bank or trust company having a minimum stated surplus and capital;

  • Requirements that the trustee both invest only in obligations maturing prior to the next distribution date and hold those obligations until maturity;
  • A limitation on the activities of the trustee to collection and distribution of income;
  • A prohibition against the trustee—

(a) exchanging Blackacre for other property;

(b) purchasing assets other than the short-term investments described above;

(c) accepting additional contributions of assets (including money) to Trust;

(d) renegotiating the terms of the debt used to acquire Blackacre; and

(e) renegotiating the lease with Tenant except in the case of Tenant’s bankruptcy or insolvency; and

(9) The termination of Trust at the earlier of 10 years or the disposition of Blackacre.

The Ruling states that Trust would have been treated as a business entity and not a trust if Trust’s trustee had a power under the trust agreement to, among other things, renegotiate the lease with its tenant, to enter into leases with other tenants, or to renegotiate or refinance the mortgage loan whose proceeds were used to purchase Blackacre.

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