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Editorial 9 MIN READ

The statutory trust, revisited

Twenty months after we walked through 12 Del. C. Ch. 38, the DST market has grown up and the questions founders ask have changed

The Editors
Staff, Incorporator.org
9 min read Updated
Contents 6 sections
  1. What actually changed in the statute
  2. Where the 1031 DST market sits in early 2019
  3. Opportunity-zone funds are not DSTs, and this matters
  4. The mutual-fund use, which is where most DSTs actually live
  5. What to tell a client in 2019
  6. Sources

Delaware statutory trust is now the default vehicle for fractional §1031 real-estate replacement, the default chassis for a new mutual fund, and the entity most often confused with a qualified opportunity fund by people who have read one article about each. The form itself has barely moved since we last covered it; the practice around it has.

We wrote the primer on the Delaware statutory trust in July 2017 and a how-to on using one for a 1031 exchange in January 2018. Twenty months and one tax overhaul later, the right-questions list looks different. This is that list.

What actually changed in the statute

The underlying statute, 12 Del. C. Chapter 38, received a round of targeted amendments in 2018 through Senate Bill 194, signed into law and made effective August 1, 2018. The bill was not a rewrite. It was a set of clarifying edits that a working practitioner would have asked for, plus one self-conscious modernization for the blockchain crowd.

The modernization first. Sections 3801(a), 3806(f)(2), 3806(g)(2), and 3819(d) were amended to confirm that a beneficial interest may be registered electronically "by means of distributed electronic networks or databases," that a vote or proxy of beneficial owners or trustees may be sent by the same means, and that trust records may be maintained on the same kind of network. In plain English: Delaware wanted the record to be clear that a DST sponsor who runs registry, voting, or recordkeeping on a distributed ledger is doing something the statute already permits. The amendment authorizes; it does not require. Almost no DST sponsor has moved to a ledger-based registry in practice, because the Investment Company Act of 1940 and the transfer agent regime layered on top of a mutual-fund DST still assume book-entry, and the 1031 DST sponsors already have registry automation that works.

The other 2018 amendments cleaned up delegation defaults under § 3806, adjusted conversion and domestication mechanics, and tightened the records provision. None of these touch the features that matter for the two use cases that dominate the form today: mutual funds registered under the 1940 Act, and fractional real-estate investment structured under Rev. Rul. 2004-86.

If you pulled a certificate of trust under § 3810 in 2017 and your trust agreement tracked the statute, you have nothing to do. The amendments do not apply retroactively in a way that would force any conforming change.

Where the 1031 DST market sits in early 2019

Rev. Rul. 2004-86 remains the ruling of record. The IRS has not superseded it, modified it, or issued competing guidance. A properly structured DST is still treated as holding real property directly for §1031 purposes, and a beneficial interest is still treated as an undivided fractional interest in that property in the hands of the beneficial owner. The seven trustee prohibitions, the ones DST lawyers call the seven deadly sins, are unchanged: no additional contributions after the offering closes, no new investments beyond the specified short-term instruments, no renegotiation of the senior debt, no renegotiation or modification of the lease, no new leases except on tenant insolvency, no more than minor structural modifications, and no reinvestment of sale proceeds. A DST that wants Rev. Rul. 2004-86 treatment is a passive vehicle, full stop.

What has changed since early 2018 is volume and standardization. DST placement through broker-dealer channels has expanded every quarter since the Tax Cuts and Jobs Act passed in December 2017, and the market now looks like a mature product category. You can get a DST into medical-office, multifamily, industrial, self-storage, student housing, or net-lease retail, most commonly at a minimum check size of $100,000 and with total offering sizes in the $30 million to $150 million range. The sponsor list has consolidated. The drop-down-then-UPREIT exit at the two-year mark (where the DST is converted into operating partnership units in a REIT) has become a standardized sponsor feature rather than a custom structure, because the two-year holding satisfies the IRS safe-harbor concern that the exchange was not entered into with a view to disposition.

The TCJA change that the 2018 piece treated as the new reality is now fully absorbed into practice. IRC §1031, as amended by Pub. L. 115-97 § 13303, applies only to real property for exchanges completed after December 31, 2017. Aircraft, railcars, equipment, artwork, and franchise intangibles can no longer use a DST for a like-kind deferral, because they cannot use §1031 at all. The Section 1031 industry that formed around personal-property exchanges has been absorbed into installment sales, opportunity zones, or straight recognition. The DST industry, which was almost entirely real-estate even before the TCJA, did not flinch.

Opportunity-zone funds are not DSTs, and this matters

The most common structural confusion we see in 2019 is the idea that a qualified opportunity fund is a kind of DST, or that a DST can be used as the fund itself. Both are wrong, and the error is worth killing at the source.

A qualified opportunity fund under IRC § 1400Z-2 must be a domestic corporation or partnership (including an LLC that elects to be taxed as a partnership) organized for the purpose of investing in qualified opportunity zone property. The statute and the October 2018 proposed regulations (REG-115420-18, published in the Federal Register at 83 Fed. Reg. 54279) specify the permitted entity forms and the self-certification on Form 8996. A DST is not on that list. A DST beneficial owner is a grantor under Subchapter J, and the trust is not taxed as a corporation or a partnership unless it affirmatively elects to be; for §1400Z-2 the partnership or corporate form is structurally required.

More fundamentally, the two vehicles are pulling in opposite directions. An opportunity fund needs active development: it has to put roughly 90% of its assets into qualified opportunity zone property, and for existing buildings it has to substantially improve them, meaning additional capital equal to the basis in the building must be invested within 30 months. "Substantially improve" is the opposite of what a DST trustee is allowed to do under Rev. Rul. 2004-86. A DST cannot make more than minor structural modifications, cannot renegotiate debt to fund improvements, cannot refinance, and cannot accept new capital after the offering closes. The DST was designed to sit still. The opportunity fund was designed to build.

Where the two do share air is in the investor base. An investor sitting on an unrecognized gain has three deferral paths available in 2019: a §1031 exchange into a DST (real-property gain only, continuing deferral, step-up at death), an opportunity-zone investment through a QOF (any capital gain, partial forgiveness at five and seven years, full forgiveness on the QOF appreciation after ten years), or an installment sale. The right answer depends on the character of the gain, the holding horizon, and the investor's estate plan, not on the entity form. A well-run RIA will quote all three. An unscrupulous one will pitch whichever pays the largest commission.

The mutual-fund use, which is where most DSTs actually live

Most of the Delaware statutory trusts in existence are not 1031 vehicles. They are open-end management investment companies registered with the SEC under the Investment Company Act of 1940, and they hold the assets of roughly 9,000 mutual-fund series across on the order of 1,500 registrants. The DST is the preferred chassis for a new fund complex because § 3804 of the DSTA permits a series structure under which the debts and obligations of one series are enforceable only against that series, and the state-law separation pairs cleanly with the 1940 Act's segregated-assets regime. Section 3806(b)(7) permits the trust agreement to grant and limit the trustees' powers in a way that maps to the independent-trustee requirements of § 10 of the 1940 Act, and § 3806(b) of the DSTA lets the governing instrument do the work that a corporate charter would otherwise have to do.

For this audience the 2018 amendments are almost a non-event. The blockchain authorization is academic for a fund complex that already operates through a transfer agent, and the delegation clarifications codified what most trust agreements already said. The one provision a fund lawyer will actually care about is the confirmation in § 3801 that electronic registration is permitted, because it forecloses a theoretical argument about whether beneficial-interest registration had to be on paper.

Funds organized as DSTs are taxed as regulated investment companies under Subchapter M of the Code, not under Subchapter J, so none of the 1031-related grantor-trust mechanics apply. The reason this matters is that a founder reading about DSTs in the real-estate press and then being told their fund lawyer is organizing a DST often assumes the two uses share tax machinery. They do not. The shared piece is the Delaware statute; everything downstream is different.

What to tell a client in 2019

If the client is a real-estate investor with a §1031 gain in motion, the DST answer is unchanged from the January 2018 piece: a properly structured DST is the only fractional vehicle the IRS will treat as direct ownership, the seven prohibitions make it a passive ride, and the sponsor economics (typically a 6% to 10% offering load plus a roughly 1% asset-management fee) should be priced in before the deferral is compared against straight recognition.

If the client has a capital gain of any kind and is considering an opportunity-zone investment, a DST is the wrong form for the fund. The QOF itself must be a corporation or a partnership, and the sponsor is almost certainly using an LLC taxed as a partnership. The DST question does not arise.

If the client is an asset manager launching a fund, the DST is probably what their counsel will propose, and the 2018 amendments did not change the analysis. Delaware remains the jurisdiction of record for registered investment company formation.

If the client has formed a DST for a private investment or a family-office vehicle and is wondering whether the 2018 amendments require any action, they do not. The certificate of trust already on file under § 3810 is still good. Amending the trust agreement to pick up the electronic-registration language is a nice-to-have and costs whatever your trust counsel charges to redline a single clause.

The one development worth keeping an eye on is the set of proposed opportunity-zone regulations issued in October 2018. A second tranche of proposed regulations is expected this spring, and it is likely to address some of the operational questions (the working capital safe harbor in the proposed rules, the treatment of leased property, the thirty-month substantial-improvement clock for already- acquired property) that will determine whether the QOF market scales the way its sponsors hope. None of that will touch the DST statute or Rev. Rul. 2004-86. It will decide whether the QOF ends up competing with the DST for the same deferral-minded investors, or whether the two products serve largely non-overlapping demand.

Twenty months ago we called the Delaware statutory trust the quiet workhorse of American structured finance. It is quieter now in the sense that nobody is debating the statute, and louder in the sense that there is a lot more money moving through it.

Sources

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