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Benefits of the Seven Deadly Sins

The Internal Revenue Ruling 2004-86 names seven deadly sins that limit the Delaware Statutory Trust ("DST") trustee's power. Deadly sins can sound intimidating and engaging in any one of these prohibited acts can have serious consequences for the DST and its beneficiaries.

However, when obeyed, these regulations provide additional protection and benefit to the beneficiaries by ensuring the trustee distributes funds properly to beneficiaries and does not take unnecessary risks with the DST's assets. Below is a list of the seven deadly sins outlined by the ruling, along with an explanation of how they can help the investor.

1. Once the offering is closed, there can be no future equity contribution to the DST by either current or new co-investors or beneficiaries.

When investors purchase beneficial interests in a DST, they purchase a percentage of ownership in the DST. If a trustee decided to accept additional contributions to the DST after the offering closed, the original investors' ownership percentages would be diluted, decreasing their claim to the DST's assets. While there are times a DST and its investors may benefit from additional contributions, the risk of additional losses is often greater than the likelihood that the increased investment will turn the struggling DST into a profitable DST.

2. The Trustee of the DST cannot renegotiate the terms of the existing loans, nor can it borrow any new funds from any other lender or party.

Loans are liabilities. When an investor purchases beneficial interest in a DST, the loan amounts are disclosed. Part of the due diligence an investor completes before purchasing shares of any DST is to understand its liabilities and decide whether or not they believe the liabilities are within reason. If a trustee is allowed to take risks and assume greater liabilities, they do so without the consent of the beneficiaries and possibly to the dissatisfaction of the beneficiaries. Since DST beneficiaries do not have the right to vote on operating decisions, the ruling prevents some actions, such as assuming debt, which can have a significant effect on the beneficiaries' interests.

3. The Trustee cannot reinvest the proceeds from the sale of its investment real estate.

The ruling requires that all proceeds earned by the DST must be distributed to the beneficiaries rather than be reinvested. By prohibiting a trustee from deciding to reinvest proceeds on behalf of the DST's beneficiaries, the IRS ensures that beneficiaries have the right to determine how and when to reinvest or use the capital earned from their investment in the DST. Often once the assets of a DST are sold, the DST sponsor will create a new DST offering, giving beneficiaries the option to reinvest their capital with the sponsor, but the investor also has the ability to find a separate investment opportunity or cash out as their own circumstances may dictate.

4. 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.

This deadly sin permits trustees to reasonably maintain the real estate property and its value, but it restricts the trustee from risking the beneficiaries' investment to upgrade the property when there can be no assurance that the cost of the upgrade will be recouped at the time of sale.

5. Any liquid cash held in the DST between distribution dates can only be invested in short-term debt obligations.

An investment in a short-term debt obligation is considered a cash equivalent because it is readily converted back into cash that can be distributed to beneficiaries at the distribution time. Because of the short-term nature of such an investment, there is little risk of change in the value. Allowance of this kind of investment gives the trustee the ability to continue to increase the value of the DST on behalf of the investors without risk of causing significant detriment to the DST's value.

6. All cash, other than necessary reserves, must be distributed to the co-investors or beneficiaries on a current basis.

DSTs are permitted to keep cash reserves so that they are prepared in the event the property requires repair or faces unexpected expenses. However, they are required to distribute earnings and proceeds to the beneficiaries within the expected timeframe. This prevents the trustee from having the ability to spend or invest the funds outside of allowable expenditures. It also protects the beneficiaries' rights to receive their income in a timely manner so they may use it as they choose rather than having it locked into the DST any longer than it should be.

7. The Trustee cannot enter into new leases or renegotiate the current leases.

Because of this deadly sin, DSTs operate well when they have invested in properties with long-term leases to creditworthy tenants on a triple-net basis. A master-lease structure to hold multifamily, student and senior housing, hospitality, and self-storage facilities are also ideal for DSTs. These types of leases provide a more secure investment in contrast to riskier year by year multi-tenant contracts that can leave properties with vacancies and less than optimal operating levels. By forcing trustees into secure leases, beneficiaries can be assured that trustees will not make risky leasing decisions. The ruling does allow for exceptions to be made in the case of a tenant bankruptcy or insolvency.

These seven deadly sins are in place as part of the regulations that allow DSTs to qualify as suitable investments for the purpose of a tax-deferred 1031 exchange. As described above, they have their benefits for investors, but, at times, can cause challenges for trustees with even the purest of intentions. In the unfortunate event that a DST finds itself in danger of losing a property because the seven deadly sins have prohibited the trustee from taking the necessary actions to remedy a problem, the state of Delaware permits the DST to convert to a Limited Liability Company ("LLC") if a provision was listed in the origination documents.

Like a DST, this Springing LLC, as it is called, contains bankruptcy remote protections for the lender and the beneficiaries. However, unlike the DST, the LLC is not restricted by the seven deadly sins, giving the trustee, now the LLC manager, the ability to raise funds or renegotiate leases as necessary to protect the property and the DST. While such a conversion can have considerable tax implications for investors because LLCs do not qualify as investments eligible to defer capital gains taxes through 1031 exchanges, converting to an LLC can rescue a DST in danger and prevent heavy losses by the beneficiaries.

Learn More About DSTs

This material does not constitute an offer to sell or a solicitation of an offer to buy any security. An offer can only be made by a prospectus that contains more complete information on risks, management fees and other expenses. This literature must be accompanied by, and read in conjunction with, a prospectus or private placement memorandum to fully understand the implications and risks of the offering of securities to which it relates. As with all investing, investing in private placements are speculative in nature and involve a degree of risk, including loss of your principal. Past performance is not necessarily indicative of future results and forward-looking statements and projections are not guaranteed to achieve the results described and your actual returns may vary significantly. Investments in private placements are illiquid in nature and there may be no secondary market or ability to sell the investment should the need for liquidity arise. This material should not be construed as tax advice and you should consult with your tax advisor as individual tax situations will vary. Securities offered through Capulent, LLC, member FINRA, SIPC.