Comparing Bands and Artists’ Solo Careers to Real Estate Investments
When a band breaks up, the musicians’ careers don’t necessarily end. Instead, the musicians’ may pursue their own solo careers or other personal projects, which can be even more successful than the band.
For instance, after the Beatles split up in 1970, Paul McCartney launched Wings, George Harrison released All Things Must Pass, John Lennon produced intimate solo records, and Ringo Starr pursued both music and film. These solo pursuits weren’t the same as their collective efforts as the Beatles, but each continued to develop individually and there was artistic value in their contributions.
The Beatles isn’t the only band to have broken up only to have individual members launch solo careers. Beyoncé left Destiny’s Child to build a solo career that dwarfed the group’s already considerable success. Peter Gabriel left Genesis to pioneer his own sound. And Sting left The Police to craft his own solo identity blending rock, jazz, and world music. While no one would claim these artists’ solo careers were the same as their work as a band member, there’s no debating that all were successful in their individual careers.
Real estate investments are similar to bands and soloists. Direct ownership of real estate is like a solo act where the owner has full control, but also full responsibility. A real estate fund, which also can be a valuable investment, isn’t the same thing because capital is pooled with the decisions made the fund manager, similar to a set list being decided by a bandleader. Both types of real estate ownership can be great investments, but they aren’t the same thing.
Tax laws recognize that a real estate fund isn’t the same thing as direct real estate ownership. Therefore, an investor can’t accomplish a Section 1031 exchange with an investment into a real estate fund.
This article is a companion to a previous article discussing how a tenant in common (TIC) investment can provide a workaround with Section 1031 investors investing along side a real estate fund. This article discusses how a Section 1031 investor can accomplish a similar result by investing in a Delaware Statutory Trust (DST).
Why Section 1031 Money Can’t Go Into a Real Estate Fund
Section 1031 exchanges allow investors defer capital gains tax by exchanging one property for another of “like-kind.” “Like-kind” is interpreted broadly, with all real estate being considered “like-kind” regardless of asset class. So, an investor can exchange agricultural land for an office building or apartment complex.
However, real estate funds aren’t “like-kind” with real estate. That’s because although the fund owns real estate, the investor buys units in a limited liability company (LLC) or an interest in a partnership, which isn’t real estate. However, just as a solo artist can join a band, there may be options for the solo investor who wants to do a Section 1031 exchange but can’t purchase units in a real estate fund
DSTs as an Alternative
In 2004, the IRS issued Revenue Ruling 2004-86 describing how DSTs can be utilized to accomplish Section 1031 exchanges. A DST is a trust created under Delaware law. The DST will hold title to real estate, with investors purchasing beneficial interests in the trust.
The DST structure sounds a lot like a real estate fund in that both the DST and the fund own real estate and the investor owns an interest in the DST or fund. The difference is that a DST doesn’t qualify for Section 1031 exchange because the trust interests are considered real estate. Rather, the DST is a fixed investment trust, which is designed to passively hold an investment, rather than to operate like a business.
To maintain its classification as a fixed investment trust, a DST must be “fixed.” That means, the trust and its assets are essentially frozen in place once formed so nothing can be changed. For instance, investors can’t contribute more capital, and the trust can’t refinance or renegotiate a mortgage loan or enter into new leases. The trust must be so passive and fixed that, unlike a real estate fund (which provides operational flexibility), the DST cannot be viewed as a business entity.
The Seven Deadly Sins of DSTs
When investors buy a DST, they don’t purchase real estate; they buy an interest in a trust, which owns real estate. The owners of a DST investment have no say in day-to-day property operations; that authority rests with a trustee. This may sound a lot like a real estate fund, where investors give up control to the fund manager. However, due to restrictions in Revenue Ruling 2004-86, a DST operates differently from a real estate fund.
To qualify for Section 1031 exchange, the DST must follow seven nonnegotiable rules designed to ensure the DST can be classified as a fixed investment trust. Since a violation of any of the seven rules will eliminate a DST’s favorable tax treatment, these rules are called the “seven deadly sins.”
Unlike a real estate fund, where the manager has flexibility to make operational, financing, and capital improvement decisions, the seven deadly sins severely restrict what the DST can do to support the real estate. To comply with Section 1031, the DST, therefore, must rigidly hold fast to the status quo, even if it becomes uncomfortable and isn’t the best thing for the property’s economic success. If a DST were compared to a band, the band wouldn’t be able to play new songs, buy new equipment, or change its rehearsal schedule or tour plans, even if the status quo was creating financial losses.
The seven deadly sins all involve activities that are considered varying or changing the investment, so it is no longer “fixed”:
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. So, upon sale of the property, each DST owner must do their own Section 1031 exchange if they want to continue to defer taxes on their gain.
Sometimes, a DST must violate one of the seven deadly sins to prevent loss of the investment. For instance, after a major fire, it might be necessary to engage in major construction or even obtain additional financing. To address this possibility, many DSTs are structured to include a “springing LLC” clause, which allows the trust to convert into an LLC in a crisis. While the springing LLC gives flexibility to do what’s necessary to protect the investment, once the LLC is ”sprung,” the DST beneficiaries may not be eligible for a Section 1031 exchange upon disposition.
Combining DSTs With Real Estate Funds
A hybrid model can provide sponsors with an opportunity to accommodate Section 1031 investors in the same investment as a real estate fund. For example, the sponsor could create a DST to own the real estate, with both the real estate fund and the Section 1031 investors as beneficial owners of the DST.
This structure requires that the fund operate without committing any of the seven deadly sins. However, since fund investors wouldn’t be concerned about doing a Section 1031 exchange out of their investment, the impact of a springing LLC wouldn’t create the same concern for fund investors as it would for Section 1031 investors. And loss of the Section 1031 exchange upon disposition usually will be better for all investors than loss of the entire investment.
Another structuring option is for both a DST and a fund to invest in real estate together through a TIC. One challenge with TIC structures is that mortgage lenders often won’t loan money for TIC ownership structure. Lenders’ primary concern about TICs relates the requirement that to qualify for Section 1031 exchange, the TICs unanimously consent to certain critical decisions. Unanimous consent can interfere with borrower negotiations with the lender in the event of a foreclosure or loan restructuring or refinancing.
However, under this TIC/DST/fund structure the DST and fund, which would own the two TICs, both would both be controlled by the same sponsor. Therefore, the sponsor would be the decisionmaker for both TICs, which might alleviate a lender’s concerns.
With all DSTs, one factor to consider, however, is cost. Due to their complex structure, DSTs are expensive to structure and cost more to maintain. If the sponsor were to sell both a real estate fund and a DST, the sponsor would need duplicate securities compliance at an additional expense. And since certain costs would be attributable to the Section 1031 compliance aspects of the DST, fund investors might not want to pay for those DST expenses.
Conclusion
Unlike a solo artist, a solo investor doing a Section 1031 doesn’t have the option to join the “band” of a real estate fund. DSTs provide possible workarounds by offering investors a structure that qualifies for 1031 treatment while still delivering a passive investment with professional management.
But DSTs have drawbacks. As fixed investment trusts, they must remain “fixed.” The seven deadly sins leave sponsors and investors in a position like a band locked into its set list, unable to add songs or buy new gear. That rigidity provides the tax benefits of tax deferral under Section 1031 but creates risk when the unexpected happens.
Some sponsors may be willing to deal with the additional cost and restrictions of a DST to gain access to additional potential investors. And for some investors, the trade-off is worthwhile: tax deferral, access to large-scale real estate, and professional management outweigh the loss of flexibility.
However, investors shouldn’t automatically assume that a Section 1031 is best for them. Sometimes, paying the taxes on their gain or pursuing another investment option might be better for their portfolio in the long run. Either way, it’s essential that both sponsors and investors understand both the benefits and the drawbacks of hybrid structures involving with DSTS and work with an attorney experienced in those structures.
© 2025 by Elizabeth A. Whitman
Any references to clients and their legal situations have been modified to protect client confidentiality.
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