And Then There Were Four. . . Deadly Sins for Delaware Statutory Trusts
Kurt Weill’s The Seven Deadly Sins is a satirical ballet chanté (sung ballet) written with German playwright Bertolt Brecht, as lyricist, in 1933, the year the composer fled Nazi Germany for Paris. The opera’s plot centers on the duality of the protagonist, Anna. Anna I is the practical opera singer, and Anna II is the freedom-seeking ballerina.
In search of the American dream, Anna visits seven United States cities over seven years. And she encounters a different deadly sin in each city. The ballet is a satirical look at capitalism, with each of the sins portrayed as a double-edged sword.
For instance, in Gluttony, Anna’s family warns her not to overeat because her contract has a weight clause, even though Anna II is already quite thin. And in Los Angeles, Anna is upset to see a movie extra being mistreated. Anna II is warned not to be angry even though it’s appropriate to be angry in seeing someone being exploited or mistreated. For lust, Anna is in love with a poor man but is persuaded to leave him for a rich man who can support her with his wealth.
In 2004, the Internal Revenue Service (IRS) created a list of “seven deadly sins” for Delaware Statutory Trusts (DSTs) in Revenue Ruling 2004-86 (Rev. Rul. 2004-86). The revenue ruling describes how a DST holding only real estate can be a fixed investment trust. If a DST doesn’t commit any of the so-called seven deadly sins, its investors can obtain tax deferral of gains on the sale of real estate similar to those they would have with a Section 1031 exchange.
Because DSTs are, by definition, fixed investment trusts, the seven deadly sins restrict investors from varying their investment (so that the investment is not “fixed”), they present unique challenges during a period of economic downturn. Earlier this year, the IRS issued Revenue Procedure 2020-34 (Rev. Proc. 2020-34), which created temporary safe harbors that relax or eliminate three of the deadly sins through the end of 2020 by allowing lease modifications, loan modifications, and additional capital contributions.
What Are the Seven Deadly Sins for DSTs?
DSTs and 1031 exchanges frequently are mentioned in the same breath, but there is a subtle difference between them. In a 1031 exchange a real estate investor sells one property and purchases another “replacement” real estate investment.
When investors buy a DST, they don’t purchase real estate. They buy an interest in a trust, which in turn owns real estate. The owners of a DST investment have no say in day-to-day property operations; that authority rests with a trustee.
DSTs have seven nonnegotiable rules they must follow, so the DST is classified as a fixed investment trust. Since a violation of any one of the seven rules will eliminate a DST’s favorable tax treatment, these rules are called the “seven deadly sins.”
The seven deadly sins all involve activities that are considered varying or changing the investment:
Once the DST offering is closed, there can be no future capital contributions, not even by existing investors.
With limited exceptions, the trustee cannot renegotiate or refinance the mortgage loan or put a new mortgage on the property.
The trustee cannot renegotiate existing leases or enter into new leases unless the tenant is insolvent or in bankruptcy.
The trustee must distribute all cash, except for a reasonable reserve for expenses, at least quarterly to owners in proportion to their percentage interests.
Any cash held by the trust must be invested in short-term investments, such as government debt or bank accounts.
The trustee may make capital expenditures only for normal repair and maintenance or for non-structural capital improvements or to bring the property into compliance with legal requirements.
The trustee may not reinvest proceeds from the sale of the property.
What Challenges Did the Seven Deadly Sins Create in the Pandemic Economic Environment?
The seven deadly sins present three challenges in the COVID-19 pandemic environment:
Tenants are experiencing financial difficulties and may require lease modifications to remain in business.
A DST may need additional capital contributions to make modifications to the building to meet CDC requirements or to make up for rent not paid by tenants who are struggling financially.
A DST may find itself in financial difficulties and need loan forbearance or modification to prevent foreclosure
Rev. Rul. 2004-86 already allowed lease modifications for insolvent tenants and loan modifications to prevent foreclosure. But it can involve some nail-biting by the trustee and its attorney when determining whether the circumstances comply with the revenue ruling’s strict requirements. And there are no built-in exceptions to the prohibition on capital contributions.
How does Rev. Proc. 2020-34 Clarify the Seven Deadly Sins?
Rev. Proc. 2020-34 creates a non-exclusive safe harbor for loan modifications, lease modifications, and additional capital contributions. DSTs that meet the safe harbor requirements will not lose their favorable tax treatment. But the revenue procedure leaves open the possibility that there will be circumstances that comply with Rev. Rul. 2004-86 but not fall under the safe harbor.
Lease Modifications
Because a DST cannot enter into new leases, property owned by a DST usually is subject to a single triple net lease. That lease may be with a commercial tenant, for example, if the property is an outbuilding occupied by a creditworthy tenant, such as a Walgreen’s or McDonald’s. Or the lease may be a master lease with a DST sponsor affiliate, which in turn subleases the property to various tenants, such as in an office building or shopping center.
Either of these lease structures could face economic challenges due to the pandemic. But the sponsor affiliate master lease is more vulnerable, as subtenants face economic challenges.
Rev. Proc. 2020-34 creates a safe harbor for lease modifications for leases entered into on or before March 13, 2020 under specified circumstances:
The modifications must have been requested and agreed to on or after March 27, 2020.
The modifications must either (1) defer or waive one or more tenant rental payments between March 27 and December 31, 2020 because the tenant is experiencing financial hardship due to COVID-19 or (2) be made to coordinate lease cash flows with certain loan forbearances and modifications described in the revenue procedure.
Because this is a non-exclusive safe harbor, this doesn’t prevent the trustee from agreeing to lease modifications that meet Rev. Proc. 2004-86’s requirements, such as when the tenant is insolvent.
Loan Modifications
On March 27, 2020, Congress enacted the Coronavirus, Aid, Relief, and Economic Security Act (CARES Act), which included provisions for mortgage loan forbearance (COVID-19 Forbearance) of government-related loans, such as those by Freddie Mac and Fannie Mae. Rev. Proc. 2020-34 creates a safe harbor for DST COVID-19 Forbearances. Rev. Proc. 2020-34 also creates a safe harbor for DST forbearances and loan modifications for non-CARES Act Forbearances under state loan forbearance programs.
Capital Contributions
Because DSTs usually can’t accept additional capital contributions and can maintain only limited reserves, they may be particularly hard-hit by the COVID-19 economic downturn. To help DSTs survive, Rev. Proc. 2020-34 temporarily eliminates the prohibition on capital contributions.
DSTs experiencing financial hardship due to COVID-19 may accept cash contributions between March 27 and December 31, 2020. The contributions must be made either to increase the DST’s allowable reserve, maintain the DST’s property, or fulfill obligations under the DST’s leases or mortgage.
The revenue procedure notes that cash contributions might come from new investors or existing DST owners. Contributions from existing owners don’t have to be proportional to their ownership interests. However, contributions from new owners or that aren’t proportional to existing ownership interests will be treated as a purchase and sale of part of the non-contributing owners’ interest in the DST.
Deciding What’s Right for Each DST
DST trustees and owners may feel constrained by Rev. Proc. 2004-86’s seven deadly sins. Likewise, in Weill’s ballet chanté, Anna likely also feels constrained by the societal norms presented in the seven deadly sins.
Weill’s Seven Deadly Sins presents a nuanced (and satirical) viewpoint on right and wrong. Anna is accused of violating one of the deadly sins for doing things that usually would be considered good. At the end of the ballet, Anna faces envy and ironically concludes that she should not envy people who enjoy life. She concludes that to be happy like others she must give up the joys of life.
Rev. Proc. 2020-34 provides much-needed flexibility for DSTs. But the revenue procedure only eliminates adverse tax consequences from violation of Rev. Rul. 2004-86. There may be other tax consequences, such as taxation of debt forgiveness.
Before deciding whether to take advantage of Rev. Proc. 2020-34, DSTs should conduct a nuanced evaluation of the tax consequences of their options. For some DSTS, the revenue procedure may facilitate changes that will enable the DST to survive and even thrive. However, loan modifications, lease modifications, and additional capital will not solve every DST’s financial woes. And those options could create undesired tax liability for the DST’s owners. For those DSTS, the better option might be to allow the investment to become another casualty of the already devastating pandemic.
© 2020 by Elizabeth A. Whitman
Any references clients and their legal situations have been modified to protect client confidentiality.
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