IRS Approves Delaware Statutory Trusts as a 1031 Exchange Vehicle

One of the basic requirements of a 1031 exchange is you must take title to the New Property in the same way you held title to your Old Property (i.e. the same tax return). For example, if you held title to your Old Property as Fred Jones, you could not take title to the New Property as Jones Investment Corporation because your Old Property was owned by your Federal 1040, whereas the Corporation files a different tax return (which will invalidate the exchange).

The IRS has a list of what they call "disregarded entities" which you might think of as exceptions to the rule (they are actually clarifications). One of these disregarded entities is a revocable living trust. If you own property in a revocable living trust, you know that the trust does not file an income tax return. All of the rents, dividends, interest, expenses, etc. arising from assets owned by the living trust are reported in your individual 1040. So, if Fred Jones owns his Old Property in the name of the "Jones Revocable Living Trust," he can sell it, do an exchange, and buy the New Property as "Fred Jones" because the same tax return owns both the Old Property and the New.

Prior to this new ruling, in addition to revocable living trusts, there were two similar types of disregarded entities: "Illinois Type Land Trusts" and "Single Member Limited Liability Companies" (LLCs). An Illinois Type Land Trust is a certain type of trust where the property is held in the name of the trust, but the multiple owners of the trust are considered the true owners -- the trust does not file a tax return. If there are three owners, then three tax returns own the property for 1031 purposes. If Fred is one of the owners, he can sell his share and buy the New Property as "Fred Jones," again because it is all the same tax return. The problem is Illinois Type Land Trusts do not protect the owners from personal liability.

LLCs do protect you from liability, but they file a partnership tax return separate from the individual members. There is no such animal, however, as a single-partner partnership. Therefore, if you try to file a tax return for an LLC with only one owner, the IRS will send it back and tell you to report the income and expenses on your own individual tax return. If Fred Jones sells his Old Property, he can buy the New Property as "Jones Investments, LLC" if he is the only member, because again, it is all the same taxpayer.

The problem has always been that if three people want to buy a property together, the lender will probably want them to take title as a "single purpose" or "bankruptcy remote" entity. The reason this is a problem is that if any of the three are trading into the property, a single purpose entity will not satisfy their exchange requirement because it files its own return. Likewise, when they sell this property, the three are joined at the hip by the single purpose entity: either they all do an exchange, or none of them do an exchange.

The good news is that the IRS has just approved the Delaware Statutory Trust (called a "DST;" also called a Delaware Business Trust) as a fourth disregarded entity for holding 1031 exchange property. This is truly a great benefit for 1031 exchange investors because DSTs are the best of all worlds: they combine the flexibility of an Illinois Type Land Trust with the asset protection benefits of an LLC.

Going back to my example of the three investors that wish to buy a property together, a DST will provide the single purpose, asset protection vehicle that a Land Trust can't because a DST is bullet proof like an LLC. At the same time it provides for multiple separate owners just like a Land Trust.

So three of you want to buy a building. You set up a DST which becomes the legal, registered owner of the building and is the bankruptcy remote borrower which satisfies the bank's loan requirements. AND for income tax purposes, the building is owned by three separate tax returns, which satisfies your 1031 exchange requirements.

...DSTs are the best of all worlds: they combine flexibility with asset protection...

The DST must have a "Trust Agreement" in place which defines the relationship of the three owners (just as you would have a partnership agreement or an LLC operating agreement). This trust agreement can be tremendously flexible because there are few requirements governing the agreement, and the agreement does not need to be filed with the state of Delaware. Furthermore, DSTs are not taxed by the state of Delaware.

There are a couple of hoops that you do have to jump through: first, you can own property in the DST, but you can not operate a business in a DST (a DST can own the Burger King building, but it can not make the hamburgers). Second, you have to have a Trustee for the DST, and the Trustee has to be a resident of the state of Delaware. The Trustee can not take independent action to buy, sell, lease or finance the property, but can be directed to do these things by the owners. And the owners can not directly collect the rent and pay the bills, but can direct the Trustee to hire a management company to do so.

I predict that DSTs will become a key component of the 1031 industry.

 

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