Did you know that a “security” does not qualify for tax deferral under Section 1031 of the Internal Revenue Code?
Did you know that a Delaware statutory trust (DST) interest is a “security?”
Then, how do securitized DST programs qualify when securities are excluded from Section 1031 exchange treatment? That is a good question.
Definition of Security
The term “security” is commonly defined as “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of a promoter or a third party,” according to the famous Howey decision rendered by the U.S. Supreme Court in 1946. Therefore, DST investments clearly constitute a “security” under applicable securities laws.
Back in the 2002-2010 era, when tenant-in-common (TIC) programs predominated, an argument was made that TIC interests could be structured as “real estate and not securities” to be sold by realtors who could lawfully earn a real estate commission. This argument was dismissed, and TICs were classified as securities by the vast majority of the alternative investment community.
DST Interests Constitute a Security
In a DST investment, the sponsor makes all decisions for the investors (the beneficial owners of the DST). Thus, DST interests are a per se security under the Howey test used to classify investment contracts. DSTs are offered and sold by FINRA-licensed broker-dealers and their registered persons who lawfully earn commissions on the sale. Realtors and others must have appropriate securities licenses to earn commissions on the sale of DSTs.
IRS Rules on DSTs
In Revenue Ruling 2004-86, the IRS considered the federal tax qualification of a multiple-owner DST formed to own rental real estate and how an exchange of real estate for an interest in the DST may qualify for exchange treatment under Section 1031. The IRS ruled that a taxpayer may exchange real estate for an interest in the DST and qualify for exchange treatment under Section 1031.
Then, how do securitized DST programs quality when securities are excluded from Section 1031? That is another good question.
Because DST interests are a hybrid.
DST interests are a security for securities laws purposes, and at the same time, constitute real estate for Section 1031 exchange purposes.
Yes, DSTs are a hybrid that qualify for Section 1031 tax treatment. That is why investors in a DST offering execute a purchase agreement for the real estate and also a subscription agreement for the securities. Revenue Ruling 2004-86 put any doubt to rest that DST interests may qualify for Section 1031 treatment in spite of being a security.
So now you know!