Drafting a DST Master Lease

In the May 2015 issue of this publication, we discussed the conversion of tenancies in common (TICs) to Delaware Statutory Trusts (DSTs) as a means of refinancing real estate projects with maturing loans while preserving the ability of the original TIC investors to dispose of their investment through a like-kind exchange in the future, and the general benefits and risks associated therewith. (See http://bit.ly/1kcJsDL.) In this article, we discuss some considerations for drafting master leases for DSTs utilized in like-kind exchanges.

A DST is a separate legal entity created as a trust under Delaware law. The importance of DSTs in connection with like-kind exchanges can be traced to Rev. Rul. 2004-86, in which the IRS ruled that an interest in a DST constituted good replacement property in an otherwise qualifying like-kind exchange involving real estate. (Note: This article focuses on the use of DSTs as part of like-kind exchanges, and particularly on syndicated offerings of DST interests to investors looking to engage in a like-kind exchange. DSTs obviously have a variety of uses outside this context to which the limitations discussed in this article may not be relevant.) This conclusion was based on the fact that: 1) the restrictions on the powers of the DST described in the ruling caused it to be classified as a trust rather than as an association or partnership for tax purposes; and 2) the trust should be disregarded for U.S. federal income tax purposes.

Under existing rules, the exchange of a beneficial interest in a trust, corporation or partnership for real estate or a similar beneficial interest in a trust, corporation or partnership does not qualify as a like-kind exchange, even if the sole asset of such entity consists of real estate. Because the provisions of the trust in Rev. Rul. 2004-86 caused it to be treated as a disregarded entity for U.S. federal income tax purposes, the acquisition of a beneficial interest in the DST, which owned rental real estate, was treated as an acquisition of an undivided interest in the underlying real estate held by the DST. Investors that had sold real estate could therefore acquire interests in a DST as replacement property in an otherwise qualifying like-kind exchange.

Limitations on Leasing Activities of DSTs

As discussed above, under Rev. Rul. 2004-86, it is essential that a DST used in a like-kind exchange be classified as a trust, rather than as a corporation or partnership, for U.S. federal income tax purposes, and that it be disregarded as an entity separate from its owners. In Rev. Rul. 2004-86, the IRS identified seven deadly sins that would cause a DST to fail to qualify as a trust. The “seven deadly sins” are derived from the historical development of the law concerning trust classification (detailed discussion of which is beyond the scope of this article), and impose several important restrictions on the operation, management and lease of real property owned by a DST that wishes to qualify under Rev. Rul. 2004-86. To qualify, it is not sufficient that a DST refrain from actually committing any of the seven deadly sins; the governing documents of the DST must provide that the DST and its trustee lack the power to commit any of the seven deadly sins.

Restrictions of the powers of DSTs relating to rental real estate include the following:

• After acquiring their interests, the beneficial owners of the DST cannot contribute additional capital. As a result, the DST is limited in its ability to obtain additional reserves and capital relating to the property, to cover tenant improvements or other costs associated with the property.
• The DST is prohibited from making more than minor, nonstructural modifications to the property that are not required by law. (Note: The IRS has not provided specific guidance as to whether the master tenant may make changes or improvements to the property that the DST cannot make. On one hand, it can be argued that the DST cannot grant the tenant the right to do something that the DST itself is prohibited from doing. On the other hand, the tenant can sublet and re-sublet the property, which the DST is also prohibited from doing.) Because of the limitations on improvements, the sponsor should consider purchasing new or newly renovated real property for these transactions in order to minimize the need for improvements during the term of the lease.
• The DST cannot renegotiate or amend leases with existing tenants or enter into new leases unless there is a tenant bankruptcy or insolvency.
• The DST cannot refinance or place new debt on the property. Thus, the term of any debt should cover the DSTs entire ownership improvement period for the property.

In most cases, this effectively limits the leasing options for a DST to: 1) a triple-net lease to a single credit-worthy tenant with a lease term that covers the DST's anticipated ownership period for the property; or 2) a triple-net master lease structure for multi-tenant properties where tenant turnover is expected. The remainder of this article focuses on certain considerations in drafting master leases in DST transactions.

General Considerations for Drafting the Master Lease

To avoid negative tax consequences, the lease must be a “true lease” for U.S. federal income tax purposes. (The parties may want to obtain an opinion from tax counsel that the lease is a true lease.) Generally, the master lease between a DST and a master tenant closely resembles a triple net lease. Under the master lease, the master tenant takes on all of the obligations related to the management of the property, including subleasing the property, and in return, receives all monies in excess of the rent paid to the DST. The master lease must be flexible and address many different scenarios because once it is effective, it cannot be amended or renegotiated unless the master tenant declares bankruptcy or becomes insolvent. Although this may seem to be a daunting task, consider that the typical ground lease may be for forty-plus years, while a DST master lease is typically much shorter, around seven to 10 years. Additionally, the master tenant is not limited in its ability to renegotiate and enter into new subleases with end users.

Special DST Provisions

As mentioned above, the “seven deadly sins” imposed by the IRS restrict the actions of the DST. Those restrictions are generally set forth in great detail in the DST trust documents. To the extent any of those restrictions could be violated by the master tenant, the master lease should also address and expressly prohibit such actions. The master lease should include a catch-all provision in which the master tenant recognizes such limitations, including those on the DST's ability to make certain repairs and modifications, and the parties' agreement not to perform any action that would cause the DST to be considered a partnership for tax purposes.

Rent

The DST cannot receive a share of any profits obtained from the property. Instead, the amount of rent that the master tenant pays the DST is fixed, typically at the amount of the debt service owed by the DST to its lender, plus an additional amount to provide a certain percentage rate of return. The master lease will be a true triple-net lease, and in addition to the rent the master tenant pays to the DST, the master tenant will also be required to pay all taxes (including all real property taxes and personal property taxes), utilities, insurance premiums, operating expenses, maintenance charges, and other costs and fees relating to the property.

Casualty and Condemnation

The casualty and condemnation provisions in the master lease require careful consideration to ensure that the master tenant will be responsible for all necessary rebuilding or repair and will not be allowed to terminate the lease, except in certain limited circumstances. Specifically:

• The master tenant should be obligated to repair any casualty to the property and should receive any insurance proceeds available for such repair. If the insurance proceeds are insufficient, the master tenant should be responsible for any costs of repairs in excess of the amounts received from insurance.
• The master tenant should have limited termination rights (e.g., right of termination only under circumstances in which a material casualty or taking occurs during the final year of the lease).
• The master tenant is not relieved of its obligation to pay rent or from any of its other obligations during the period of repair or restoration.
• In the case of a taking of less than the entire property, so long as the master tenant can use the property for the same purposes and can restore the property with the proceeds of the taking, the master tenant should not be able to terminate. The lease should also specify that a partial taking is not an eviction.

Insurance

Because most of the risk of operating the property falls on the master tenant and this tenant is typically a special-purpose entity with limited assets, and because the master lease cannot be renegotiated once it is executed, the DST should ensure that the master tenant is adequately insured and consider the following insurance requirements:

• special form or all-risk property and fire insurance (including an endorsement for malicious mischief and vandalism) in an amount not less than the full replacement cost of the property, as adjusted from time to time, with a specified deductible;
• rent loss insurance and business interruption insurance, as applicable; and
• flood hazard, boiler and machinery coverage for mechanical and electrical failure, and earthquake insurance, if applicable.

The master lease should require the master tenant to provide, annually and upon the DST's request, not only certificates of insurance, but complete copies of all insurance policies, endorsements, and renewals.

Assignment and Subletting

While it is customary practice for the landlord in a commercial lease to limit the tenant's rights to assign or sublease, it is important for the DST to: 1) prohibit assignment by the master tenant without consent, as any assignment by the master tenant would constitute an amendment to the lease, which is prohibited by the “seven deadly sins”; but 2) allow for the master tenant to sublease and manage subtenants freely, as the master tenant is responsible for managing all ongoing subleasing activity on the property.

When All Else Fails

If an unexpected event requires the DST to do something that it does not have the power to do within the parameters set by the IRS (e.g., if the DST is in danger of losing the real property due to an impending default on the loan and the trustee cannot act), the DST's trust documents often allow the DST to “kickout” or contribute the assets of the DST to a limited liability company or partnership, which then distributes the assets to the beneficiaries. This effectively terminates the DST and has the consequence of prohibiting the DST beneficiaries from exchanging their interests in the DST's property for other real property in a tax-free, like-kind exchange. Accordingly, the master lease should expressly allow the DST to assign the lease freely, including to a partnership or LLC.

Conclusion

While the master lease between a DST and master tenant will look similar to a standard triple-net lease, there are certain requirements and limitations to preserve the investors' ability to engage in tax-free like-kind exchanges that require special attention and consultation with tax counsel. By requiring the master tenant to acknowledge and abide by the limitations placed upon the DST, the DST can better ensure that its beneficiaries retain the tax benefits that incentivized them to invest in the DST in the first place.

Marisa Byram, a member of this newsletter's Board of Editors, is an Equity Member of Lewis Rice and works in the firm's Real Estate Department. Michael T. Donovan is also an Equity Member, and Chairman of the firm's Tax Department. Andrea M. Patton is an Associate at the firm.

In the May 2015 issue of this publication, we discussed the conversion of tenancies in common (TICs) to Delaware Statutory Trusts (DSTs) as a means of refinancing real estate projects with maturing loans while preserving the ability of the original TIC investors to dispose of their investment through a like-kind exchange in the future, and the general benefits and risks associated therewith. (See http://bit.ly/1kcJsDL.) In this article, we discuss some considerations for drafting master leases for DSTs utilized in like-kind exchanges.

A DST is a separate legal entity created as a trust under Delaware law. The importance of DSTs in connection with like-kind exchanges can be traced to Rev. Rul. 2004-86, in which the IRS ruled that an interest in a DST constituted good replacement property in an otherwise qualifying like-kind exchange involving real estate. (Note: This article focuses on the use of DSTs as part of like-kind exchanges, and particularly on syndicated offerings of DST interests to investors looking to engage in a like-kind exchange. DSTs obviously have a variety of uses outside this context to which the limitations discussed in this article may not be relevant.) This conclusion was based on the fact that: 1) the restrictions on the powers of the DST described in the ruling caused it to be classified as a trust rather than as an association or partnership for tax purposes; and 2) the trust should be disregarded for U.S. federal income tax purposes.

Under existing rules, the exchange of a beneficial interest in a trust, corporation or partnership for real estate or a similar beneficial interest in a trust, corporation or partnership does not qualify as a like-kind exchange, even if the sole asset of such entity consists of real estate. Because the provisions of the trust in Rev. Rul. 2004-86 caused it to be treated as a disregarded entity for U.S. federal income tax purposes, the acquisition of a beneficial interest in the DST, which owned rental real estate, was treated as an acquisition of an undivided interest in the underlying real estate held by the DST. Investors that had sold real estate could therefore acquire interests in a DST as replacement property in an otherwise qualifying like-kind exchange.

Limitations on Leasing Activities of DSTs

As discussed above, under Rev. Rul. 2004-86, it is essential that a DST used in a like-kind exchange be classified as a trust, rather than as a corporation or partnership, for U.S. federal income tax purposes, and that it be disregarded as an entity separate from its owners. In Rev. Rul. 2004-86, the IRS identified seven deadly sins that would cause a DST to fail to qualify as a trust. The “seven deadly sins” are derived from the historical development of the law concerning trust classification (detailed discussion of which is beyond the scope of this article), and impose several important restrictions on the operation, management and lease of real property owned by a DST that wishes to qualify under Rev. Rul. 2004-86. To qualify, it is not sufficient that a DST refrain from actually committing any of the seven deadly sins; the governing documents of the DST must provide that the DST and its trustee lack the power to commit any of the seven deadly sins.

Restrictions of the powers of DSTs relating to rental real estate include the following:

• After acquiring their interests, the beneficial owners of the DST cannot contribute additional capital. As a result, the DST is limited in its ability to obtain additional reserves and capital relating to the property, to cover tenant improvements or other costs associated with the property.
• The DST is prohibited from making more than minor, nonstructural modifications to the property that are not required by law. (Note: The IRS has not provided specific guidance as to whether the master tenant may make changes or improvements to the property that the DST cannot make. On one hand, it can be argued that the DST cannot grant the tenant the right to do something that the DST itself is prohibited from doing. On the other hand, the tenant can sublet and re-sublet the property, which the DST is also prohibited from doing.) Because of the limitations on improvements, the sponsor should consider purchasing new or newly renovated real property for these transactions in order to minimize the need for improvements during the term of the lease.
• The DST cannot renegotiate or amend leases with existing tenants or enter into new leases unless there is a tenant bankruptcy or insolvency.
• The DST cannot refinance or place new debt on the property. Thus, the term of any debt should cover the DSTs entire ownership improvement period for the property.

In most cases, this effectively limits the leasing options for a DST to: 1) a triple-net lease to a single credit-worthy tenant with a lease term that covers the DST's anticipated ownership period for the property; or 2) a triple-net master lease structure for multi-tenant properties where tenant turnover is expected. The remainder of this article focuses on certain considerations in drafting master leases in DST transactions.

General Considerations for Drafting the Master Lease

To avoid negative tax consequences, the lease must be a “true lease” for U.S. federal income tax purposes. (The parties may want to obtain an opinion from tax counsel that the lease is a true lease.) Generally, the master lease between a DST and a master tenant closely resembles a triple net lease. Under the master lease, the master tenant takes on all of the obligations related to the management of the property, including subleasing the property, and in return, receives all monies in excess of the rent paid to the DST. The master lease must be flexible and address many different scenarios because once it is effective, it cannot be amended or renegotiated unless the master tenant declares bankruptcy or becomes insolvent. Although this may seem to be a daunting task, consider that the typical ground lease may be for forty-plus years, while a DST master lease is typically much shorter, around seven to 10 years. Additionally, the master tenant is not limited in its ability to renegotiate and enter into new subleases with end users.

Special DST Provisions

As mentioned above, the “seven deadly sins” imposed by the IRS restrict the actions of the DST. Those restrictions are generally set forth in great detail in the DST trust documents. To the extent any of those restrictions could be violated by the master tenant, the master lease should also address and expressly prohibit such actions. The master lease should include a catch-all provision in which the master tenant recognizes such limitations, including those on the DST's ability to make certain repairs and modifications, and the parties' agreement not to perform any action that would cause the DST to be considered a partnership for tax purposes.

Rent

The DST cannot receive a share of any profits obtained from the property. Instead, the amount of rent that the master tenant pays the DST is fixed, typically at the amount of the debt service owed by the DST to its lender, plus an additional amount to provide a certain percentage rate of return. The master lease will be a true triple-net lease, and in addition to the rent the master tenant pays to the DST, the master tenant will also be required to pay all taxes (including all real property taxes and personal property taxes), utilities, insurance premiums, operating expenses, maintenance charges, and other costs and fees relating to the property.

Casualty and Condemnation

The casualty and condemnation provisions in the master lease require careful consideration to ensure that the master tenant will be responsible for all necessary rebuilding or repair and will not be allowed to terminate the lease, except in certain limited circumstances. Specifically:

• The master tenant should be obligated to repair any casualty to the property and should receive any insurance proceeds available for such repair. If the insurance proceeds are insufficient, the master tenant should be responsible for any costs of repairs in excess of the amounts received from insurance.
• The master tenant should have limited termination rights (e.g., right of termination only under circumstances in which a material casualty or taking occurs during the final year of the lease).
• The master tenant is not relieved of its obligation to pay rent or from any of its other obligations during the period of repair or restoration.
• In the case of a taking of less than the entire property, so long as the master tenant can use the property for the same purposes and can restore the property with the proceeds of the taking, the master tenant should not be able to terminate. The lease should also specify that a partial taking is not an eviction.

Insurance

Because most of the risk of operating the property falls on the master tenant and this tenant is typically a special-purpose entity with limited assets, and because the master lease cannot be renegotiated once it is executed, the DST should ensure that the master tenant is adequately insured and consider the following insurance requirements:

• special form or all-risk property and fire insurance (including an endorsement for malicious mischief and vandalism) in an amount not less than the full replacement cost of the property, as adjusted from time to time, with a specified deductible;
• rent loss insurance and business interruption insurance, as applicable; and
• flood hazard, boiler and machinery coverage for mechanical and electrical failure, and earthquake insurance, if applicable.

The master lease should require the master tenant to provide, annually and upon the DST's request, not only certificates of insurance, but complete copies of all insurance policies, endorsements, and renewals.

Assignment and Subletting

While it is customary practice for the landlord in a commercial lease to limit the tenant's rights to assign or sublease, it is important for the DST to: 1) prohibit assignment by the master tenant without consent, as any assignment by the master tenant would constitute an amendment to the lease, which is prohibited by the “seven deadly sins”; but 2) allow for the master tenant to sublease and manage subtenants freely, as the master tenant is responsible for managing all ongoing subleasing activity on the property.

When All Else Fails

If an unexpected event requires the DST to do something that it does not have the power to do within the parameters set by the IRS (e.g., if the DST is in danger of losing the real property due to an impending default on the loan and the trustee cannot act), the DST's trust documents often allow the DST to “kickout” or contribute the assets of the DST to a limited liability company or partnership, which then distributes the assets to the beneficiaries. This effectively terminates the DST and has the consequence of prohibiting the DST beneficiaries from exchanging their interests in the DST's property for other real property in a tax-free, like-kind exchange. Accordingly, the master lease should expressly allow the DST to assign the lease freely, including to a partnership or LLC.

Conclusion

While the master lease between a DST and master tenant will look similar to a standard triple-net lease, there are certain requirements and limitations to preserve the investors' ability to engage in tax-free like-kind exchanges that require special attention and consultation with tax counsel. By requiring the master tenant to acknowledge and abide by the limitations placed upon the DST, the DST can better ensure that its beneficiaries retain the tax benefits that incentivized them to invest in the DST in the first place.

Marisa Byram, a member of this newsletter's Board of Editors, is an Equity Member of Lewis Rice and works in the firm's Real Estate Department. Michael T. Donovan is also an Equity Member, and Chairman of the firm's Tax Department. Andrea M. Patton is an Associate at the firm.