If I Buy a Leveraged Dst, Do I Get the Loan Amount Back?

A few sponsors we follow have arranged for cash out transactions in DSTs they have recently syndicated in the retail channel, which has turned the cash out concept into a hot topic with our clients. The IPA's Direct Insights Call on DSTs last month addressed these new structures. So what are we to make of them? Is it even accurate to call these transactions "refinancings," which is how they are referred to around the industry?

How does a cash out transaction work for DSTs?

Conceptually, with a cash out transaction, a trust would return to investors a significant portion of their capital contributions in a DST by assuming financing on the property owned by the DST after the offering closes. Investors would continue to own the same percentage of beneficial interests in the DST after the financing; however, their ownership would now consist of equity and the assumption of a proportionate share of debt. The mechanics of the cash out transaction are designed to comply with IRS's Revenue Ruling 2004-84, which allows for tax deferral of the entire original invested amount under section 1031 for DST investments. More on that in a minute.

Let's look at how this would work hypothetically. Say that Sally Smith sells a rental duplex for $400,000, $250,000 of which would constitute taxable gain. Instead of pocketing the proceeds, she undertakes a compliant, tax-deferred 1031 exchange (through use of a qualified intermediary, of course) into the beneficial interests of a DST that owns a medical office building that is not yet encumbered by debt. However, prior to closing, the sponsor had already negotiated long term financing with a lender at a 65% LTV, and for its part, signed the loan agreement on behalf of the trust. Three months after Sally purchases her interests in the trust, the mortgage lender countersigns the agreement and funds the loan, the proceeds of which the trust distributes to investors. In a non-taxable event, Sally receives $260,000 of her original $400,000 investment (assuming none of that went into load or transaction costs), and she keeps $140,000 remaining in the trust, which has taken on the obligation to repay the loan.

In essence, the concept is intended to allow an investor to defer taxes on a gain in a relinquished property through a 1031 exchange, and then access much/all of that gain as a return of equity (which would not result in boot) potentially shortly after the 1031 transaction, to use as the investor sees fit. This contrasts with the typical scenario, in which 100% of the proceeds invested through a 1031 exchange remains in the trust for up to ten years, and afterward investors either need to roll sales proceeds into another 1031, or else pay taxes on deferred gains.

The legal theory

It's important to consider that this concept appears untested from a 1031 compliance standpoint, given that it is a recent innovation in the syndicated DST space. There is no direct case law on point, or explicit guidance from the IRS, as to the permissibility of a cash out transaction post-close in the DST context. As far as we know, no sponsor has obtained a private letter ruling on the viability of any particular cash out arrangement.

Revenue Ruling 2004-84 spells out "seven deadly sins" that a trustee must not have the power to commit for a trust arrangement to be respected for federal tax purposes. The trustee must not be able to "vary the investment" of the trust beneficiaries (i.e., investors), or else it could jeopardize the tax deferral treatment under section 1031 of the original investment transaction. Among the impermissible sins is a power under the trust agreement to renegotiate or refinance obligations used to purchase the property.

Sally's hypothetical above depends on the theory that the trustee has no power to renegotiate the terms of the loan or enter into new financing after Sally's investment—the trustee has bound the trust to the terms that it negotiated by signing the loan agreement before investors acquired their interests. Once the trustee is thus committed, the lender has the sole discretion to countersign and fund the loan in the future or not. Under this theory, the investors are purchasing their beneficial interests in a trust in which the prospect of the (re)financing is part of the "fixed" nature of the intended investment. Under this line of thinking, calling it a cash out "refinancing" is a misnomer, not only prejudicial.

Even if the cash out transaction concept can be squared with the letter of the seven deadly sins, it may still need to withstand application of common law doctrines courts may use to recharacterize transactions, among other potential challenges. For instance, use of the step transaction doctrine could recast the initial 1031 investment and subsequent loan closing into a single transaction, the sole intent of which was allegedly for the investors to avoid payment of taxes. Of course, any such characterization would depend on individual facts and circumstances.

There is no doubt that cash out transactions for DSTs present a tantalizing prospect. If the concept is ever validated from an administrative and/or legal standpoint, it will likely revolutionize the syndicated 1031 landscape. But high reward might come with unique risks.

Approach tax risk with caution

Whatever legal and tax arguments we could marshal for and against cash out structures, the IRS's and tax courts' ultimate positions on them are far more important than our musings, and are currently unknown. A "should" level opinion from reputable tax counsel (which only addresses narrow, federal tax law questions) is always a perquisite for DST offerings. Such opinion may take on a heightened importance in a cash out context, even though, again, there isn't much direct authority to draw from. At the very least, we'd look for the opinion to address questions surrounding classification as a trust for federal tax purposes in light of the cash out and the common law doctrines the IRS could conceivably try to use to recharacterize the original 1031 transaction. And of course, a tax opinion is never a guarantee of how the IRS would attempt to treat any particular transaction, and might not protect investors from tax penalties in the event of an adverse result. And even if the IRS ever blesses the DST cash out concept or merely declines to challenge these transactions, state regulators could still attack them to disallow tax deferral on the state tax level.

Don't overlook the execution risk

Apart from the tax considerations, remember that in our hypothetical case, the lender is not obligated to countersign the agreement and make the loan. If conditions in the capital markets change during the period between syndication and loan, and the lender backs out of the deal, not only wouldn't investors get their substantial distribution of equity, but they might be stuck with unfavorable return prospects without debt.

Another way to assess execution risk is to consider whether it would it make sense to invest into the DST after the financing has closed (if possible). Of course, there would be no prospect of a return of significant equity, but investment after loan funding would eliminate the potential tax risk highlighted in this post, and make the execution issue moot. What do cash-on-cash and exit scenarios look like in absence of the contemplated leverage? Could investors live with those (and without the cash out) if the anticipated loan is not funded?

Consider the economics

Also, make sure you understand the interplay of the economics of initial investment, the loan transaction, and subsequent cash out. Is the investor paying a load on the full amount of equity, even as much/most of the equity would be shortly returned to the investor? Is there any write-down of the equity after the loan is closed? Will the remaining equity in the deal be highly leveraged, subjecting investors to an increased risk profile? It's certainly possible that the cash out benefits outweigh any drawback in the transactional mechanics, or that these mechanics significantly diminish the anticipated benefits.

There are a lot of other legal and practical wrinkles related to DST cash out financing that we'll continue to parse. As it stands now, the most critical question is how tax authorities and courts will eventually address these arrangements, if at all. Does the cash out structure constitute an impermissible end run around the purpose of section 1031—to promote continuity of investment in like-kind property? Or does it represent a code-compliant innovation of clever tax lawyers and sponsors on par in ingenuity with syndicated 1031 investment itself? Or will the IRS, states, and tax courts take a different position altogether? We'll be monitoring with significant interest.

Of course, it probably goes without saying that we cannot explore all of the relevant tax issues in this space. This blog post does not constitute legal or tax advice. Broker dealers, registered investment advisors, wealth managers, and their clients should consult their own tax, legal, and accounting advisors prior to any transaction.

If I Buy a Leveraged Dst, Do I Get the Loan Amount Back?

Source: http://blog.factright.com/what-to-make-of-cash-out-transactions-in-dsts

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