DST 1031 Exchange: Rev. Rul. 2004-86 Rules and Limits

A Delaware statutory trust (DST) can be 1031 replacement property because the IRS ruled, in Rev. Rul. 2004-86, that an interest in a DST meeting specific limits is treated as a direct, undivided interest in the trust’s real estate, not as a “certificate of trust or beneficial interest” excluded by §1031. The limits are strict: once the trust is formed, the trustee can’t change the investment.

What the ruling holds

The ruling’s facts: an individual buys Blackacre with a 10-year nonrecourse loan, signs a 10-year net lease with one tenant, and contributes the property to a DST. Two other taxpayers exchange their real property for all the DST interests through a qualified intermediary.

The IRS held two things. First, the DST is an “investment trust” classified as a trust under Reg. §301.7701-4(c), because it has a single class of interests and the trustee has no “power to vary the investment.” Second, because it’s a grantor trust, each owner is treated as owning an undivided fractional interest in Blackacre, so the exchange of real property for a DST interest can qualify under §1031 “if the other requirements of § 1031 are satisfied.”

The limits on the trustee

The trust agreement in the ruling restricts the trustee to collecting and distributing income. The trustee may not:

• exchange Blackacre for other property, or buy assets other than permitted short-term investments
• accept additional contributions of assets, including money
• renegotiate the loan used to buy Blackacre
• renegotiate the lease, or lease to other tenants, except if the tenant goes bankrupt or insolvent
• make more than “minor non-structural modifications” to the property, unless required by law

Cash between quarterly distributions, and reserves, can only go into short-term US government obligations or bank certificates of deposit that mature before the next distribution date. The trustee must distribute available cash, less reasonable reserves, every quarter.

The ruling then says what goes wrong. If the trustee could (i) dispose of the property and buy new property, (ii) renegotiate the lease or lease to other tenants, (iii) renegotiate or refinance the loan, (iv) invest cash to profit from market fluctuations, or (v) make more than minor non-structural changes not required by law, the DST would be a business entity, taxed as a partnership if it has two or more owners. A partnership interest isn’t eligible replacement property.

The IRS loosened these limits once, temporarily. Rev. Proc. 2020-34 let DSTs accept certain COVID-19 loan forbearances, lease modifications and cash contributions made in 2020 without being treated as having a power to vary. It applied only to actions in that window and says no inference should be drawn for actions outside its scope.

The springing LLC

Because a DST’s trustee can’t raise money or refinance, offering documents may provide a fallback. Delaware law allows a statutory trust to “convert to an other business entity” such as an LLC (12 Del. C. §3821), and a provision for converting the trust when the property needs action the trustee can’t take is known as a springing LLC. After conversion, the entity is no longer the trust the ruling describes, and an eligible entity with two or more members is a partnership by default unless it elects otherwise (Reg. §301.7701-3(b)(1)). The tax consequences for investors depend on the facts at the time. Whether a particular DST has such a provision, and what triggers it, is in its trust agreement and private placement memorandum.

DST interests are securities

DST interests are securities. A private offering of them under Regulation D, Rule 506 can go one of two ways.

	Rule 506(b)	Rule 506(c)
Advertising	Not allowed (no general solicitation)	Allowed
Who can buy	Accredited investors, plus up to 35 non-accredited purchasers in any 90-day period who are financially sophisticated	Accredited investors only
Verification	Issuer must reasonably believe purchasers qualify	Issuer must take “reasonable steps to verify” accredited status

Under Rule 501(a), a natural person is an accredited investor with:

• net worth over $1,000,000, alone or with a spouse or spousal equivalent, not counting the primary residence (and with special rules for mortgage debt on it), or
• income over $200,000 in each of the two most recent years ($300,000 jointly with a spouse or spousal equivalent), with a reasonable expectation of the same this year, or
• certain professional credentials the SEC has designated.

Entities have their own tests in Rule 501(a).

Fees, illiquidity and what to read

DST interests aren’t traded on a public market; the trust in Rev. Rul. 2004-86 itself was “not publicly traded on an established securities market” and ran for a fixed term of up to 10 years or until the property was sold. Transfer rights, redemption (if any) and the expected holding period are set by each offering’s documents.

Fees and compensation are disclosed in each offering’s private placement memorandum. They differ by offering, so read the PPM’s compensation and use-of-proceeds sections rather than relying on any general figure. The PPM is also where you’ll find the property, the lease, the loan terms, the sponsor’s conflicts and the risk factors.

What Form D does and doesn’t show

The issuer must file a Form D notice with the SEC within 15 calendar days after the first sale (Rule 503). It’s a notice, not an SEC review of the offering. Form D reports:

• the issuer and its related persons
• the exemption claimed, 506(b) or 506(c)
• the date of first sale
• the minimum investment accepted
• total offering amount, amount sold and amount remaining
• number of investors, and how many are non-accredited
• sales commissions and finders’ fees, in dollars, which the filer can mark as estimates
• the broker-dealers paid to sell it

It doesn’t show the property’s location, the lease, distributions, the loan, fees other than sales compensation, or current availability. Our DST offerings data republishes Form D fields only, as a public record. It isn’t an offer, a recommendation or a list of available investments.

Using a DST in your identification

A DST interest goes on your 45-day identification like any other replacement property, and it has to be “unambiguously described” (Reg. §1.1031(k)-1(c)(3)). The usual limits apply:

• 3-property rule: any three properties of any value. A DST interest named as a backup uses one of the three.
• 200% rule: any number of properties, if their combined value at day 45 is no more than 200% of what you sold. Under this rule you can name a primary property plus one or more DSTs, as long as the total stays within 200%.
• 95% rule: if you exceed both, you must acquire at least 95% of the value identified.

Example with round numbers: you sell for $2,000,000. Under the 200% rule you could identify a $2,500,000 building and a $1,500,000 DST interest ($4,000,000 total, exactly 200%). If the building falls through, you can close on the DST interest by day 180. Identifying a specific DST doesn’t guarantee its interests are still available when you’re ready to close.

DST purchases still have to meet the value and debt rules for full deferral. See boot in a 1031 exchange and the 1031 exchange rules.

This page is general information, not a recommendation of any DST or sponsor. Questions about DST offerings belong with your own financial adviser and the sponsor’s offering documents; this site doesn’t take DST investment requests.

Sources

• Rev. Rul. 2004-86 (IRB 2004-33)
• Rev. Proc. 2020-34
• Treas. Reg. §301.7701-4
• Treas. Reg. §301.7701-3
• Treas. Reg. §1.1031(k)-1
• 17 CFR 230.501 (accredited investor)
• 17 CFR 230.503 (Form D filing)
• 17 CFR 230.506
• 12 Del. C. §3821, conversion of a statutory trust