Is Your TIC Client a Candidate for Conversion to DST?

Under existing IRS guidance, taxpayers disposing of real estate may invest in real property owned through a tenancy in common (TIC) or a Delaware Statutory Trust (DST) as part of a qualifying tax-deferred like-kind exchange, so long as the TIC or DST arrangement meets certain requirements. Many commercial loans financing TIC arrangements are reaching maturity. As a result of the crash of the real estate market in 2008, and certain features of TIC arrangements that may make them less attractive to lenders, some TICs may face difficultly in refinancing. In such cases, one option for dealing with refinancing issues may be to convert the TIC to a DST. This article explains the reasons converting to a DST may facilitate a refinancing and discusses factors to keep in mind when considering the conversion of a TIC to a DST, most notably, for purposes of this article, certain leasing limitations.

Background

Section 1031 of the Internal Revenue Code provides that a taxpayer does not recognize gain or loss for income tax purposes if property held for productive use in a trade or business or for investment is exchanged solely for property of a like-kind which is to be held for productive use in a trade or business or for investment. Thus, like-kind exchanges under Section 1031 allow taxpayers to defer recognition of gain on the disposition of real property if they acquire other real property in a like-kind exchange that satisfies the requirements of Section 1031.

Under Section 1031, an exchange of a fee simple interest in real property for an undivided interest in real property as a tenant in common qualifies for like-kind exchange treatment. However, an exchange of real property for an interest in a partnership does not qualify for like-kind exchange treatment, even when the sole asset of the partnership consists of real estate. Prior to the issuance of Revenue Procedure 2002-22, it was far less clear whether a syndicated TIC interest would be treated as an undivided interest in property qualifying for like-kind exchange treatment or as a partnership interest that did not qualify. Rev. Proc. 2002-22 provided some guidance on this issue by laying out the conditions under which the purchase of an undivided interest in real estate would qualify for like-kind exchange treatment, setting the stage for syndicated TIC offerings.

In a syndicated TIC deal, the sponsor obtained financing for the TIC property and marketed interests to potential investors, who purchased undivided interests in the property subject to pro rata shares of the loan. Syndicated TIC investments provided several other advantages to investors. By buying undivided interests as tenants in common with other investors, TIC investors could pool their investment with other individuals, allowing them to invest in larger properties and different real estate classes from those in which they could invest on their own. For example, an individual could sell an apartment building and buy a TIC interest in a commercial property triple-net leased to Walgreens or another credit-worthy tenant. Syndicated TIC investments also typically provided for professional management through a management agreement or triple-net lease, relieving investors of the need to manage the properties.

As a result of the fact that many loans used to finance syndicated TIC investments had 10-year terms, many of the loans are now coming due and TIC investors must decide to sell the real property or refinance the loans.

Refinancing TIC Properties

Since the collapse of the real estate market in 2008, financing for TIC transactions has become more difficult to obtain. Several aspects of TIC arrangements may make them less attractive to lenders:

1. TIC arrangements may involve up to 35 separate and unrelated co-owners and co-borrowers to the loan, each with their own property interests. As a result: a) All investors (including, for investor entities, the owners of such entities) must be vetted for creditworthiness. This can make loan underwriting expensive and time consuming; b) In the event of foreclosure, the lender must foreclose on up to 35 separate borrowers, each of which could theoretically put forth separate defenses. Additionally, if one borrower files bankruptcy, that could postpone the foreclosure process for the entire TIC. TIC Agreements often address the risk that the bankruptcy of one TIC poses to the others by giving the other TIC investors the right to purchase the interest of the bankrupt TIC investor.
2. While loans in syndicated TIC deals are generally nonrecourse, TIC arrangements typically involve heavy negotiations regarding non-recourse carve-outs. Rev. Proc. 2002-22 limits the ability of TIC investors to assume liability for the bad acts of other investors or the sponsor, making it more complicated for the lender to obtain protection against default.
3. Under Rev. Proc. 2002-22, all major decisions regarding the TIC property, including the sale or refinancing of the property and the execution of new leases, require unanimous consent from all investors, encouraging investors to leverage hold-out positions against each other.
4. Transferring an interest is cumbersome, requiring the transferee to assume the loan and the lender to underwrite the transferee.
5. Under Rev. Proc. 2002-22, each TIC investor must retain the right to partition the property, so one investor could force a sale through partition that could result in an unauthorized transfer and loan default. TIC agreements typically mitigate this risk by giving the other TIC investors an option to purchase the interest of an investor who wishes to seek partition.
6. Upon the maturing of the loan encumbering the TIC property, TIC investors generally have three options, all of which require the unanimous agreement of all TIC investors before implementation: a) Sell the property prior to the maturity date. The sponsor or an affiliate will typically assume responsibility for marketing the property in exchange for a fee. The sale will trigger recognition of the deferred gain from the investor's original like-kind exchange unless the investor can structure the disposition of the TIC property as a like-kind exchange. Some loan agreements may also require the payment of exit fees for sale prior to maturity; b) Contribute the TIC interests to a limited liability company that is treated as a partnership for U.S. federal income tax purposes and provide each TIC investor a membership interest in the LLC. The latter is a more attractive borrower from the lender's perspective since it is the sole owner of the property, the sole borrower on the loan, and the LLC provisions provide more flexibility in structuring the terms of the loan. The investors do not realize gain or loss at the time of the contribution, but it is extremely difficult to structure the disposition of the property by the LLC as a like-kind exchange. Thus, any deferred gain from the investor's original like-kind exchange is likely to be triggered at the time the LLC disposes of the property; c) Convert the TIC into a DST. In Revenue Ruling 2004-86, the IRS held that a beneficial interest in a DST that owns real estate would be treated as a direct interest in real estate and would be eligible for like-kind exchanges of real estate, as long as certain conditions were met.

Delaware Statutory Trust (DST) Background and Considerations

A DST is a separate legal entity created as a trust under Delaware law. The DST is structured so that all beneficiaries own a beneficial interest in the trust and the DST owns the entire fee interest in the property. However, the DST must be a passive holder of the real estate. The powers of the trustee must be restricted to avoid causing the DST to be characterized as a partnership for federal income tax purposes. The investor beneficiaries of the DST only have the right to receive distributions. This means that the DST structure is typically used to purchase properties with highly rated long-term tenants under triple-net leases or properties leased to an affiliate of the transaction sponsor, who can then manage the property and lease it to end tenants.

DSTs are comparatively more attractive to lenders and investors for a variety of reasons:

1. The DST owns the entire fee interest in the property and is the single borrower under the loan agreement. Thus, the lender only has to deal with one borrower.
2. DST beneficiaries have no power to make management decisions. The lender can therefore deal with one decision maker. Since they have no power to commit acts that could trigger a non-recourse carve-out, individual investors do not need to be made liable on non-recourse carve-outs.
3. DSTs are bankruptcy remote, so creditors of the beneficiary investors cannot reach the DST property.
4. Investors can structure an exit from a DST as a like-kind exchange. A DST is not suitable for all properties, however. Treasury Regulations and Rev. Rul. 2004-86 prohibit a DST from taking many actions that may be necessary to protect the investment in the property.
5. No additional capital contributions can be made to the DST after its initial formation and acquisition of the property. This could be problematic if the reserves of the DST prove inadequate.
6. The DST cannot sell the real estate and acquire new property.
7. All cash proceeds of the property, other than necessary cash reserves, must be distributed to the beneficiaries on a current basis.
8. The property cannot be refinanced and the terms of existing loans cannot be renegotiated. Thus, conversion to the DST can be used to refinance the TIC property, but the DST cannot refinance the property thereafter.
9. The trustee cannot enter into new leases or renegotiate existing leases on the property (unless the tenant is bankrupt or insolvent).
10. The trustee can only make normal repairs and maintenance, minor non-structural capital improvements, and legally required repairs and improvements to the property.

Typically, a DST is designed to deal with these limitations in two ways:

1. The real estate owned by the DST is leased pursuant to a long-term, triple-net lease either with a single creditworthy tenant or with an affiliate of the sponsor (with the affiliate then leasing the property to end users). If the TIC is already party to a lease with an existing tenant, conversion to a DST may require that the DST enter into a master lease with an affiliate of the sponsor, which could raise other issues, such as whether the conversion triggers a default under the previously existing lease or requires a non-disturbance agreement.
2. If the DST is required to take a prohibited action, the DST agreement typically provides that the property can be “kicked out” to an LLC which has the power to take the necessary actions. However, as noted above, since the LLC is treated as a partnership for tax purposes, it generally will be difficult for investors to structure the disposition of the property by the LLC as a like-kind exchange. Thus, the investors generally will recognize their deferred gain from their like-kind exchange at the time the LLC disposes of the property.

Conclusion

In summary, conversion to a DST may provide an attractive alternative for TICs seeking to refinance their loans on TIC properties. However, the requirement that the DST be a passive holder of real estate and the limitations on the DST's ability to take certain actions may not make a DST suitable in all cases.

Michael T. Donovan is an Equity Member of Lewis Rice and Chairman of the firm's Tax Department. He can be reached at 314-444-7715 or [email protected]. Andrea Patton is an Associate at the firm, concentrating her practice in corporate transactional work.

Under existing IRS guidance, taxpayers disposing of real estate may invest in real property owned through a tenancy in common (TIC) or a Delaware Statutory Trust (DST) as part of a qualifying tax-deferred like-kind exchange, so long as the TIC or DST arrangement meets certain requirements. Many commercial loans financing TIC arrangements are reaching maturity. As a result of the crash of the real estate market in 2008, and certain features of TIC arrangements that may make them less attractive to lenders, some TICs may face difficultly in refinancing. In such cases, one option for dealing with refinancing issues may be to convert the TIC to a DST. This article explains the reasons converting to a DST may facilitate a refinancing and discusses factors to keep in mind when considering the conversion of a TIC to a DST, most notably, for purposes of this article, certain leasing limitations.

Background

Section 1031 of the Internal Revenue Code provides that a taxpayer does not recognize gain or loss for income tax purposes if property held for productive use in a trade or business or for investment is exchanged solely for property of a like-kind which is to be held for productive use in a trade or business or for investment. Thus, like-kind exchanges under Section 1031 allow taxpayers to defer recognition of gain on the disposition of real property if they acquire other real property in a like-kind exchange that satisfies the requirements of Section 1031.

Under Section 1031, an exchange of a fee simple interest in real property for an undivided interest in real property as a tenant in common qualifies for like-kind exchange treatment. However, an exchange of real property for an interest in a partnership does not qualify for like-kind exchange treatment, even when the sole asset of the partnership consists of real estate. Prior to the issuance of Revenue Procedure 2002-22, it was far less clear whether a syndicated TIC interest would be treated as an undivided interest in property qualifying for like-kind exchange treatment or as a partnership interest that did not qualify. Rev. Proc. 2002-22 provided some guidance on this issue by laying out the conditions under which the purchase of an undivided interest in real estate would qualify for like-kind exchange treatment, setting the stage for syndicated TIC offerings.

In a syndicated TIC deal, the sponsor obtained financing for the TIC property and marketed interests to potential investors, who purchased undivided interests in the property subject to pro rata shares of the loan. Syndicated TIC investments provided several other advantages to investors. By buying undivided interests as tenants in common with other investors, TIC investors could pool their investment with other individuals, allowing them to invest in larger properties and different real estate classes from those in which they could invest on their own. For example, an individual could sell an apartment building and buy a TIC interest in a commercial property triple-net leased to Walgreens or another credit-worthy tenant. Syndicated TIC investments also typically provided for professional management through a management agreement or triple-net lease, relieving investors of the need to manage the properties.

As a result of the fact that many loans used to finance syndicated TIC investments had 10-year terms, many of the loans are now coming due and TIC investors must decide to sell the real property or refinance the loans.

Refinancing TIC Properties

Since the collapse of the real estate market in 2008, financing for TIC transactions has become more difficult to obtain. Several aspects of TIC arrangements may make them less attractive to lenders:

1. TIC arrangements may involve up to 35 separate and unrelated co-owners and co-borrowers to the loan, each with their own property interests. As a result: a) All investors (including, for investor entities, the owners of such entities) must be vetted for creditworthiness. This can make loan underwriting expensive and time consuming; b) In the event of foreclosure, the lender must foreclose on up to 35 separate borrowers, each of which could theoretically put forth separate defenses. Additionally, if one borrower files bankruptcy, that could postpone the foreclosure process for the entire TIC. TIC Agreements often address the risk that the bankruptcy of one TIC poses to the others by giving the other TIC investors the right to purchase the interest of the bankrupt TIC investor.
2. While loans in syndicated TIC deals are generally nonrecourse, TIC arrangements typically involve heavy negotiations regarding non-recourse carve-outs. Rev. Proc. 2002-22 limits the ability of TIC investors to assume liability for the bad acts of other investors or the sponsor, making it more complicated for the lender to obtain protection against default.
3. Under Rev. Proc. 2002-22, all major decisions regarding the TIC property, including the sale or refinancing of the property and the execution of new leases, require unanimous consent from all investors, encouraging investors to leverage hold-out positions against each other.
4. Transferring an interest is cumbersome, requiring the transferee to assume the loan and the lender to underwrite the transferee.
5. Under Rev. Proc. 2002-22, each TIC investor must retain the right to partition the property, so one investor could force a sale through partition that could result in an unauthorized transfer and loan default. TIC agreements typically mitigate this risk by giving the other TIC investors an option to purchase the interest of an investor who wishes to seek partition.
6. Upon the maturing of the loan encumbering the TIC property, TIC investors generally have three options, all of which require the unanimous agreement of all TIC investors before implementation: a) Sell the property prior to the maturity date. The sponsor or an affiliate will typically assume responsibility for marketing the property in exchange for a fee. The sale will trigger recognition of the deferred gain from the investor's original like-kind exchange unless the investor can structure the disposition of the TIC property as a like-kind exchange. Some loan agreements may also require the payment of exit fees for sale prior to maturity; b) Contribute the TIC interests to a limited liability company that is treated as a partnership for U.S. federal income tax purposes and provide each TIC investor a membership interest in the LLC. The latter is a more attractive borrower from the lender's perspective since it is the sole owner of the property, the sole borrower on the loan, and the LLC provisions provide more flexibility in structuring the terms of the loan. The investors do not realize gain or loss at the time of the contribution, but it is extremely difficult to structure the disposition of the property by the LLC as a like-kind exchange. Thus, any deferred gain from the investor's original like-kind exchange is likely to be triggered at the time the LLC disposes of the property; c) Convert the TIC into a DST. In Revenue Ruling 2004-86, the IRS held that a beneficial interest in a DST that owns real estate would be treated as a direct interest in real estate and would be eligible for like-kind exchanges of real estate, as long as certain conditions were met.

Delaware Statutory Trust (DST) Background and Considerations

A DST is a separate legal entity created as a trust under Delaware law. The DST is structured so that all beneficiaries own a beneficial interest in the trust and the DST owns the entire fee interest in the property. However, the DST must be a passive holder of the real estate. The powers of the trustee must be restricted to avoid causing the DST to be characterized as a partnership for federal income tax purposes. The investor beneficiaries of the DST only have the right to receive distributions. This means that the DST structure is typically used to purchase properties with highly rated long-term tenants under triple-net leases or properties leased to an affiliate of the transaction sponsor, who can then manage the property and lease it to end tenants.

DSTs are comparatively more attractive to lenders and investors for a variety of reasons:

1. The DST owns the entire fee interest in the property and is the single borrower under the loan agreement. Thus, the lender only has to deal with one borrower.
2. DST beneficiaries have no power to make management decisions. The lender can therefore deal with one decision maker. Since they have no power to commit acts that could trigger a non-recourse carve-out, individual investors do not need to be made liable on non-recourse carve-outs.
3. DSTs are bankruptcy remote, so creditors of the beneficiary investors cannot reach the DST property.
4. Investors can structure an exit from a DST as a like-kind exchange. A DST is not suitable for all properties, however. Treasury Regulations and Rev. Rul. 2004-86 prohibit a DST from taking many actions that may be necessary to protect the investment in the property.
5. No additional capital contributions can be made to the DST after its initial formation and acquisition of the property. This could be problematic if the reserves of the DST prove inadequate.
6. The DST cannot sell the real estate and acquire new property.
7. All cash proceeds of the property, other than necessary cash reserves, must be distributed to the beneficiaries on a current basis.
8. The property cannot be refinanced and the terms of existing loans cannot be renegotiated. Thus, conversion to the DST can be used to refinance the TIC property, but the DST cannot refinance the property thereafter.
9. The trustee cannot enter into new leases or renegotiate existing leases on the property (unless the tenant is bankrupt or insolvent).
10. The trustee can only make normal repairs and maintenance, minor non-structural capital improvements, and legally required repairs and improvements to the property.

Typically, a DST is designed to deal with these limitations in two ways:

1. The real estate owned by the DST is leased pursuant to a long-term, triple-net lease either with a single creditworthy tenant or with an affiliate of the sponsor (with the affiliate then leasing the property to end users). If the TIC is already party to a lease with an existing tenant, conversion to a DST may require that the DST enter into a master lease with an affiliate of the sponsor, which could raise other issues, such as whether the conversion triggers a default under the previously existing lease or requires a non-disturbance agreement.
2. If the DST is required to take a prohibited action, the DST agreement typically provides that the property can be “kicked out” to an LLC which has the power to take the necessary actions. However, as noted above, since the LLC is treated as a partnership for tax purposes, it generally will be difficult for investors to structure the disposition of the property by the LLC as a like-kind exchange. Thus, the investors generally will recognize their deferred gain from their like-kind exchange at the time the LLC disposes of the property.

Conclusion

In summary, conversion to a DST may provide an attractive alternative for TICs seeking to refinance their loans on TIC properties. However, the requirement that the DST be a passive holder of real estate and the limitations on the DST's ability to take certain actions may not make a DST suitable in all cases.

Michael T. Donovan is an Equity Member of Lewis Rice and Chairman of the firm's Tax Department. He can be reached at 314-444-7715 or [email protected]. Andrea Patton is an Associate at the firm, concentrating her practice in corporate transactional work.