The Tenant-In-Common or TIC Investment Property structure was developed in the early 1990's and became exceptionally popular after the Treasury Department issued Revenue Procedure 2002-22 in March of 2002, which established certain guidelines pursuant to which the Internal Revenue Service (IRS) would consider issuing Private Letter Rulings (PLRs) regarding ownership interests in TIC Investment Properties acquired as replacement property as part of a 1031 Exchange transaction.
It is important to note that these guidelines did not offer "safe harbor" or "guaranteed" structures for TIC Investment Properties, but they did provide guidance for TIC Brokers and TIC Sponsors to use in structuring and distributing (selling) interests in TIC Investment Properties. Certain weaknesses and limitations of the Tenant-In-Common Investment Properties were discovered as the real estate market went through The Great Recession.
TIC Sponsors and TIC Brokers and their commercial lenders invested significant resources in developing an alternative co-investorship or fractional ownership structure that would overcome the weaknesses and limitations of the traditional TIC Investment Property offerings. The result was the co-investorship or fractional ownership structure known as the Delaware Statutory Trust or DST.
The Internal Revenue Service issued Revenue Ruling 2004-86 on August 16, 2004, which permitted the use of the co-investorship or fractional ownership structure of the Delaware Statutory Trust or DST to qualify as replacement properties as part of an investor's 1031 Exchange transaction.
In order for a TIC offering to be considered a real estate transaction for 1031 Exchange purposes, it must follow the guidelines established in Revenue Procedure 2002-22. One of the guidelines requires that there be no more than 35 co-investors. This limit restricts the size of TIC Investment Property transactions that can be brought to market by TIC Sponsors.
The minimum investment required from each individual TIC investor increases along with the purchase price of the investment property. A TIC Investment Property that costs $150 million with $75 million in bank financing would require a minimum investment from each TIC investor of $2,142,857 ($75,000,000/35). It becomes more difficult for TIC Sponsors to raise equity capital from investors as the size of the TIC Investment Properties increase.
Another limitation is the challenge to create and administer up to 35 single-purpose, single-member limited liability companies (LLCs) and simultaneously arrange for lender financing with those 35 single-purpose, single member LLCs. Lenders often limit the total number of co-investors in a TIC Investment Property transaction to less than the permissible 35 co-investors in order to make the underwriting and closing process less cumbersome.
Individual single member limited liability companies are not set-up as part of the Delaware Statutory Trust or DST Investment Property structure. The individual investors become beneficiaries and own individual beneficial interests in the Delaware Statutory Trust or DST. There is no need under the DST Investment Property structure to set up singe-purpose, single-member LLCs for each investor.
Instead, each co-investor owns an individual beneficial interest in the Delaware Statutory Trust. The DST itself shields the co[investor from liability with respect to the underlying investment property owned and held inside the DST. This saves the co-investor substantial annual expense with respect to the formation costs and annual fees associated with the single-purpose, single-member LLC. It also provides a less complex structure for the co-investor.
Individual co-investors in a Tenant-In-Common or TIC Investment Property structure must vote unanimously on all major investment decisions. It can be impossible to get all of the individual TIC Investment Property co-investors to agree on major decisions. The individual co-investors or beneficiaries in a Delaware Statutory Trust, however, are not permitted to vote. Therefore, concern that a single co-investor or beneficiary might hold up the process is eliminated.
There is no need for a lender to obtain copies of income tax returns, financial statements, or credit authorizations from each co-investor for purposes of loan qualification since the DST is the borrower and not each individual co-investor.
In a DST transaction, the trust owns 100% of the fee interest in the real estate, so unlike the TIC structure, there is only one loan and one borrower. There is also no restriction on the number of investors in a DST, as opposed to a TIC transaction, which is limited to 35 investors. As a result, larger properties can be purchased without causing investment minimums to rise to unacceptable levels.
Most importantly, the Delaware Statutory Trust or DST Investment Property structure qualifies for tax-deferred exchange treatment under Section 1031 of the Internal Revenue Code ("1031 Exchange").
Delaware Statutory Trusts or DSTs prevents any potential creditors, lien holders/liens, or judgments of any of the co-investors from attaching to the investment property held in the Delaware Statutory Trust. The lender therefore has greater security in foreclosing on the Promissory Note and Deed of Trust or Mortgage should it become necessary to do so.
There is no one-year time limit for the property management contract with the property manager, so the lender will have comfort knowing that the Delaware Statutory Trust Sponsor will be operating the DST Investment Property without interruption.
The individual co-investors or beneficiaries in the Delaware Statutory Trust do not individually qualify for the loan nor do they have to go through any of the lender's underwriting requirements because the individual co-investors or beneficiaries of the Delaware Statutory Trust are not the borrowers. The Delaware Statutory Trust is the borrower and the Trustee of the Delaware Statutory Trust executes all of the loan documents.
Internal Revenue Ruling 2004-86, which forms the income tax authority for structuring a Delaware Statutory Trust or DST transaction for use with a 1031 Exchange has prohibitions over the powers of the Trustee of the Delaware Statutory Trust of DST, which are known as the "seven deadly sins," and include the following:
Once the offering is closed, there can be no future equity contribution to the Delaware Statutory Trust or DST by either current or new co-investors or beneficiaries.
The Trustee of the Delaware Statutory Trust or DST cannot renegotiate the terms of the existing loans, nor can it borrow any new funds from any other lender or party.
The Trustee cannot reinvest the proceeds from the sale of its investment real estate.
The Trustee is limited to making capital expenditures with respect to the property to those for a) normal repair and maintenance, (b) minor non-structural capital improvements, and (c) those required by law.
Any liquid cash held in the Delawre Statutory Trust or DST between distribution dates can only be invested in short-term debt obligations.
All cash, other than necessary reserves, must be distributed to the co-investors or beneficiaries on a current basis, and
The Trustee cannot enter into new leases or renegotiate the current leases.
The Delaware Statutory Trust of DST agreement may contain a provision that provides that if the Trustee determines that the DST is in danger of losing the property due to its inability to act because of the prohibitions in the trust agreement (the seven deadly sins), it can convert the Delaware Statutory Trust or DST into a limited liability company (hereinafter referred to as the Springing LLC) with pre-existing agreed-upon terms.
The laws of the state of Delaware permit the conversion to a limited liability company through a simple filing with the office of the Secretary of State. The Springing LLC will contain the same bankruptcy remote provisions as the Delaware Statutory Trust of DST for the lender's benefit, but it will not contain the prohibitions against the raising of additional funds, the raising of new financing or the renegotiation or the terms of the existing debt or entering into new leases. In addition, it will provide that the Trustee will become the manager of the limited liability company.
Co-investors or beneficiaries looking for the tax benefits of a 1031 Exchange coupled with the advantages of co-ownership or fractional ownership in investment real estate are increasingly seeking the popular alternatives of Delaware Statutory Trusts or DST co-investor. Recently, the Delaware Statutory Trusts or DSTs have been gaining popularity for a number of reasons including the ability to secure financing more easily and attract more co-investors with lower minimum investment requirements.
The Internal Revenue Service issued Revenue Ruling 2004-86 that sets out the guidelines for the Delaware Statutory Trust or DST. Delaware Statutory Trusts are trusts that are considered to be separate legal entities pursuant to the trust laws of the state of Delaware.
Each individual that co-invests in or through a Delaware Statutory trust or DST is a beneficiary of the Delaware Statutory Trust and therefore owns a "beneficial interest" in the DST for Federal income tax purposes. The co-investor or beneficiary is treated as owning an undivided fractional interest in the underlying investment real property.
One of the primary benefits of the Delaware Statutory Trust or DST Investment Property structure is the ease of obtaining financing compared to the Tenant-In-Common or TIC Investment Property structure. Lenders view the Delaware Statutory Trust as one borrower even though there can be up to 99 individual investors or beneficiaries.