Choosing the Right Legal Structure for Your 1031 Exchange: DSTs vs TICs vs QOFs

One of the primary restrictions is that a DST cannot renegotiate existing loan terms or enter into new financing arrangements. This rule helps maintain the passive investment status required for 1031 exchanges. However, this restriction can limit opportunities to refinance at lower interest rates, which could otherwise increase cash flow. Additionally, DST properties may be forced to sell when the loan matures, even if the property market is down or the asset is experiencing temporary challenges. This could lead to a loss. In such cases, other investment structures, like Tenants-In-Common (TIC), which allow refinancing, may be preferable.

DSTs are prohibited from entering into new leases or renegotiating existing ones, posing a challenge for properties with frequent lease turnovers, such as multifamily units or self-storage facilities. Sponsors often work around this restriction by creating a subsidiary that enters into a "Master Tenant Lease" with the DST. The sponsor can then negotiate subleases freely. However, this often leads to a complex legal structure with uncertain cash flow strategies and potential hidden tax implications.

DSTs cannot make significant capital improvements or repairs beyond normal and routine maintenance. While this rule enforces a conservative business plan, it may not appeal to investors seeking higher potential returns through value-added opportunities. These investors may prefer other entities, such as TICs, which allow for more flexibility in capital expenditures.

If a DST sells a property, the proceeds must be distributed to investors rather than reinvested in new property. This rule prevents changes in the investment portfolio that could jeopardize the DST's tax status. However, if a DST holds multiple properties and sells part of the portfolio, investors may face the challenge of conducting multiple small 1031 exchanges or paying taxes. While sponsors typically aim to sell the entire portfolio at once, failure to do so can result in a complicated tax situation for investors.

DSTs can maintain only limited reserves for property operations, typically up to 3% of the property's value, intended for normal maintenance and operations. These reserves cannot be used for significant improvements or changes and must be placed in conservative short-term investments. Any excess reserves must be distributed to investors. While this rule creates transparency and accountability, it also means that sponsors may be unable to build up cash reserves in anticipation of future economic challenges, potentially limiting the DST's financial resilience.

A DST must avoid any active business operations, restricting its activities to collecting rent and paying operating expenses related to the property. Engaging in business activities could alter the DST's nature, affecting its eligibility for 1031 exchanges. This restriction ensures that cash reserves are only used for property expenses or distributed to investors, preventing the sponsor from mismanaging funds through poor or irresponsible investments.

Investors cannot make additional capital contributions to the DST after their initial investment. This ensures the investment remains static and prevents modifications that could alter the trust's nature. The inability to conduct a capital call without risking the 1031 exchange eligibility requires sponsors to maintain substantial reserves. These reserves, which may be taxable and restricted to property expenses, can be a disadvantage for investors who prefer the flexibility of contributing additional capital as needed.

Neither DSTs nor TICs are considered liquid assets, as there is no formal secondary market for either. However, ownership in both structures is transferable, meaning a DST or TIC owner can theoretically sell their shares to another investor in a secondary transaction.

For TICs, selling shares can be more challenging if the property was purchased with a mortgage because the bank typically needs to underwrite each TIC owner. This additional requirement complicates the transfer process. In contrast, DSTs do not have this underwriting requirement, potentially making the transfer of ownership easier.

For investors seeking a straightforward, turnkey solution, DSTs are typically more suitable. DSTs can accommodate up to 99 investors, compared to TICs, which are limited to 35 investors. Additionally, DSTs often have lower minimum investment amounts and require less administrative effort upon closing.

For TICs, each investor must be underwritten by the lender if the property was purchased with a loan. TIC sponsors frequently establish a single-member LLC for each investor to provide legal protection and prevent personal liability for the loan. Coordinating these factors often extends the closing process for TICs compared to DSTs.

However, the certainty of close in DSTs comes at a cost. Expensive bridge loans and high marketing expenses needed to warehouse DSTs for investors can add to the overall cost. These bridge loans often come with lender agreements that may pose risks if the sponsor fails to sell sufficient equity in the DST. Investors must assess how much of a premium they are willing to pay for the certainty of close offered by DSTs.

Both DST and TIC investors report income on Schedule E of their tax returns and can depreciate their property to shelter income for tax purposes. However, TIC investors receive a property deed, whereas DST investors do not. This difference can affect how ownership is perceived and managed from a tax perspective.

Both DSTs and TICs can offer non-recourse debt to investors, which allows them to:

1. Replace the debt from the property they sold and purchase property of equal or greater value to satisfy their 1031 exchange.
2. Acquire more property to potentially amplify their upside potential.
3. Buy additional property to increase the basis for their investment and gain potential tax benefits through depreciation.

A significant difference between TICs and DSTs lies in their refinancing capabilities. DSTs cannot refinance without jeopardizing the structural integrity of the DST's master lease. This limitation can prevent DST investors from benefiting from lower interest rates if they drop or from extending the property's lifespan if the property encounters financial difficulties. Most commercial properties have balloon loans that mature after 7-10 years, potentially forcing a DST to sell the property at a loss when the loan matures. On the other hand, TICs have no such refinancing restrictions, offering more flexibility to refinance and potentially increase returns.

Refinancing is often a crucial component of a real estate investment's business plan. If interest rates fall, refinancing can increase income for investors. Although some sponsors have successfully assumed mortgages with low interest rates, these loans may only have 4-7 years remaining. This scenario might not be ideal for a DST, which cannot refinance, but it could be an excellent opportunity for a TIC that can refinance when the note is due, thus benefiting from years of potential cash flow from the low interest rate.

DST sponsors are prohibited from taking a cut of any potential appreciation (often referred to as a "waterfall"), unlike other syndication structures such as LLCs, partnerships, or REITs. Instead, DST sponsors earn most of their profit upfront through the "load," with an additional disposition fee upon the sale of the property.

From one perspective, this fee structure appeals to investors because the sponsor does not take a percentage of the property's appreciation. If the property appreciates by 100%, the investor retains all the gains minus closing costs and the disposition fee.

However, some investors view this fee structure as a potential misalignment of interests, as the sponsor is compensated regardless of the property's performance. In contrast, TICs may involve fewer upfront fees and allow the sponsor to share in a percentage of the returns. Proponents of this fee structure believe it better aligns the interests of the investor and sponsor, ensuring both parties are motivated by the property's success.

TICs offer investors a more flexible structure that can be attractive to those with an appetite for higher returns. While DSTs provide a turnkey solution, they are often restrictive. DSTs are not permitted to:

• Contribute capital after the DST offering period.
• Renegotiate loans.
• Enter into new lease arrangements.
• Invest cash reserves.
• Undertake major construction projects.
• Reinvest the proceeds from property sales.

These restrictions ensure the DST maintains its passive investment status, which is necessary for 1031 exchange eligibility. However, these limitations can also prevent DSTs from responding dynamically to market conditions or taking advantage of potential growth opportunities.

Delaware Statutory Trust (DST) offers passive ownership with built-in debt and no management responsibilities. Tenants-in-Common (TIC) provides more control and refinancing flexibility but requires more involvement. Qualified Opportunity Funds (QOF) allow investment of capital gains from any asset type into designated opportunity zones with potential tax benefits.

The Seven Deadly Sins are IRS restrictions that DSTs must follow: no renegotiating loans, no new leasing, no major capital expenditures, no reinvesting proceeds from sales, excess reserves must be distributed, no business operations, and no future capital contributions.

Yes, unlike DSTs, TIC investments can be refinanced. This flexibility allows TIC investors to potentially benefit from lower interest rates and extend property lifespans, making them potentially more suitable for longer-term investment strategies.

QOF investments may be suitable for investors with capital gains from non-real estate assets (stocks, art, businesses) who want to defer taxes while investing in opportunity zones. QOFs require only gains to be reinvested, not the entire proceeds like 1031 exchanges.