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Trust Law/Level VII · Property and business/7.2 Business/Lesson 3

Delaware statutory trusts

How a Delaware statutory trust works as a separate entity, what it is used for, and the limits Rev. Rul. 2004-86 sets for §1031 exchanges.

Education, not legal advice. Trust law changes from country to country and state to state, and the right structure depends on your situation. Anything you sign should be drafted or reviewed by a qualified lawyer where you live.

The lean path

The cheapest, lowest-tax, simplest and most private route the law allows, best first. Each step names the rule it rests on and the condition that keeps it lawful.

  1. The simplest route may be to sell and pay the tax, or to hold until death for a stepped-up basis under IRC §1014; a DST exchange fits owners who want passive real estate and can hold long-term.
  2. To defer gain, identify replacement DST interests within 45 days of transferring the relinquished property and complete the exchange within 180 days (IRC §1031(a)(3)), without taking the sale cash yourself.
  3. The DST must stay within Rev. Rul. 2004-86: no new capital, no refinancing, no new leases and no reinvestment; if the trustee gains those powers it becomes a partnership and the exchange fails.
  4. Sponsor fees vary and are disclosed in the offering documents; compare them with buying a replacement property directly, and expect interests to be hard to sell before the property itself is sold.
  5. Since 2018 §1031 covers only real property, and gain is deferred, not forgiven: it carries into the DST interest’s basis and must still be reported for the exchange year.

MaterialsThe Delaware Statutory Trust Act, 12 Del. C. ch. 38 (§3801 and following), on delcode.delaware.govRev. Rul. 2004-86 on irs.gov, especially the facts listing what the trustee may not doLesson 7.2.1, on how business trusts are classified for federal tax, and lesson 7.1.5, on holding rental property in trust

Wonder

  1. How can a trust be a legal entity that sues and is sued in its own name?
  2. Why would an interest in a trust count as real estate for a tax-deferred exchange?
  3. What does an investor give up when the trustee’s hands are tied?

Explore

  1. Delaware’s statutory trust law dates from 1988, when the Delaware Business Trust Act was enacted; it was renamed the Delaware Statutory Trust Act in 2002 and is codified at 12 Del. C. ch. 38. A statutory trust is formed under a governing instrument and by filing a certificate of trust with the Delaware Secretary of State (§3810). Unless its certificate and governing instrument provide otherwise, it is a separate legal entity (§3801), and it may sue and be sued in its own name.
  2. Unless the governing instrument says otherwise, beneficial owners get the same limit on personal liability as stockholders of Delaware for-profit corporations (§3803(a)), and trustees acting in that role are generally not personally liable to outsiders for the trust’s obligations (§3803(b)). The Act leaves wide freedom to the governing instrument, which is why the form suits very different uses: mutual funds (lesson 7.2.2), securitisation issuers (lesson 6.2.6) and real estate interests sold to individual investors.
  3. For real estate investors the key text is Rev. Rul. 2004-86. The IRS ruled that the Delaware statutory trust it described was an ‘investment trust’ under Treas. Reg. §301.7701-4(c), classified as a trust rather than a business entity, because it had a single class of interests and the trustee had no power to vary the investment. Under the grantor trust rules each investor was treated as owning an undivided fractional interest in the property. So exchanging real property for an interest in that trust could qualify as a like-kind exchange under IRC §1031, if the other §1031 requirements were met.
  4. Industry writers call the ruling’s limits the ‘seven deadly sins’; the label is informal and does not appear in the ruling. On the ruling’s facts the trustee could not accept further contributions of money or property; renegotiate the loan or borrow more; exchange the property or reinvest proceeds in other assets; renegotiate the lease or take new tenants, except on the tenant’s bankruptcy or insolvency; make more than minor non-structural changes not required by law; or hold cash other than in short-term government obligations and bank deposits maturing before the next distribution. Cash, less reasonable reserves, had to be distributed quarterly. The IRS said that wider powers would make the trust a business entity, usually a partnership, and the exchange would not qualify.
  5. Those limits make the tax result possible, and they also shape the investment. Because the trustee cannot refinance, re-lease or raise new money, a property in trouble can be hard to rescue; some trust agreements allow conversion into an LLC in that case, which can have tax consequences of its own. Interests are generally not traded on an exchange and can be hard to sell before the property itself is sold. Offerings carry sponsor fees and costs that vary by offering and must be read in the offering documents; this lesson gives no typical figure.
  6. Delaware law and federal tax are separate questions: a trust can be a valid Delaware statutory trust and still be a partnership for tax if its trustee has too much power. Since 2018, after the 2017 tax law, §1031 applies only to exchanges of real property, so the ruling matters mainly for real estate. This lesson explains the law; it does not suggest using a Delaware statutory trust or any offering, and anyone considering an exchange should have a qualified adviser review the specific documents.

Key facts

  • The Delaware Statutory Trust Act was enacted in 1988 as the Delaware Business Trust Act and renamed in 2002; it is 12 Del. C. ch. 38.
  • A Delaware statutory trust is formed by a governing instrument and a certificate of trust filed with the state, and is a separate legal entity unless its documents provide otherwise.
  • Beneficial owners of a Delaware statutory trust get the same limit on personal liability as stockholders of Delaware for-profit corporations, unless the governing instrument says otherwise.
  • Rev. Rul. 2004-86 held that a Delaware statutory trust with a single class of interests and no power to vary the investment is an investment trust classified as a trust.
  • Under that ruling, investors are treated as owning undivided interests in the property, so exchanging real property for a trust interest can qualify under IRC §1031.
  • The ‘seven deadly sins’ is an informal name for the ruling’s limits on the trustee, such as no new contributions, no refinancing, no new leases and no reinvestment.

Exercise nine, six, three, one

9CollectList up to 9 features of a Delaware statutory trust described in this lesson, the Act or an offering summary you are reading (some lists are shorter), such as how it is formed, who manages it, what the trustee may not do and how investors can exit.
6ClusterSort them into 6 categories: formation, liability, the trustee’s powers, tax classification, investor exit and costs, and facts you are unsure about.
3DistillReduce the 6 categories to 3 groups: features required by Delaware law, features needed for the Rev. Rul. 2004-86 tax result, and features chosen by the sponsor.
1CrystallizeWrite 1 sentence explaining, in your own words, why limiting a trustee’s powers can change how the IRS classifies a trust.

Fact check

Dates, figures and claims checked against the published sources listed below.

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