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COVID-19 has reshaped our life drastically. Many countries are facing first, second, and even third waves of surging cases at the moment. Although strict lockdowns might have saved millions of lives, the global economy is sliding into a mire on a scale as we have never witnessed before. In the US, the pandemic has caused massive disruptions to the economy. Large corporations are undergoing a painful restructuring process, many small businesses are bankrupt, and tens of thousands of renters default their rent payments after being furloughed or losing their jobs. All these significantly impact Delaware Statutory Trust (DST), particularly those involving like-kind properties under 1031 Exchange. Compared to other types of trusts, DST is exceptionally vulnerable to the current economic turmoil.
The Drawbacks
DST has become a prevalent investment tool for financing properties, but it possesses several fatal weaknesses. It is better to lay them out here briefly before going into the recent government reliefs since they are closely linked.
As one of the advantages of gathering financial resources, the numbers of DST investors are unlimited. However, once a DST is concluded, it is highly restricted to invite more investors or accept additional financial contributions. The reason behind it is to protect the original investors’ ownerships from being diluted. Because the beneficiaries of DST cannot participate in the operation of the Trust, the Trustee is prohibited from borrowing or negotiating new loans, which could alter the financial liabilities of the beneficiaries. The profit gained from DST cannot be used by the Trustee to reinvest. Instead, it must be distributed among the beneficiaries based on the agreement. Although a predetermined amount of cash in the DST is permitted to be retained from distribution, earnings and proceeds must be handed over to the beneficiaries promptly on the agreed dates. In line with preventing the Trustee from risking beneficiaries’ interest, the Trustee is prohibited from renegotiating the existing lease or entering a new lease, unless a tenant enters into bankruptcy or insolvency.
The Fallout.
In the context of the economy going downhill, many businesses in the long-term property lease with DSTs cannot make their ends meet due to lack of revenue. As a result, the horror of DST’s drawbacks surfaces. The leassor (DST) and the leasee (firms) find themselves trapped in a set of terms and conditions that are almost unrealistic to fulfil in the current circumstance, yet neither has the legal power to alter. Because according to the law, the existing lease with a DST cannot be renegotiated. Furthermore, DSTs do not have any effective means to stop, but only to see themselves bleeding to death because the law does not permit them to acquire new loans or amend loan terms or accept more financial contributions to mitigate the economic hardship.
The Update
Facing these conundrums, the Internal Revenue Service (IRS) released Rev. Proc. 2020-34. It provides temporary relief to the DSTs to continue benefiting from 1031 like-kind exchanges through adjusting their mortgage loans, renegotiating agreements or even taking in additional cash contributions, which were all prohibited previously.
– Loan Modification
Under the safe harbour elaborated in Rev. Proc. 2020-34, certain modifications of mortgage loans in connection with forbearance programs are permitted. In the case of mortgage loans held by real estate mortgage investment conduits (REMICs) and investment trusts, Rev. Proc. 2020-26 applies to the following:
- Forbearance (and all related modifications) of a Federally backed mortgage loan or a Federally backed multifamily mortgage loan, if the forbearance is provided under section 4022 or 4034, respectively, of the CARES Act (CARES Act Forbearances); and
- The loans were granted to borrowers who are experiencing a financial hardship due, directly or indirectly, to the COVID-19 emergency.
The forbearance programs target the loans for up to six months that the borrowers requested or agreed between March 27, 2020, and December 31, 2020.
– Cash Contribution
Apart from the default prohibitions that restrict DSTs to accept cash contributions, many loan providers are reluctant to modify the mortgage terms with the DSTs who cannot demonstrate sufficient cash flow or case reserve in the context of COVID-19. Therefore, in order to realize the practical sense of loan modifications permitted above, it is sensible to proffer temporary relaxation on the rule of cash contribution as well.
Rev. Proc. 2020-34 allows DSTs to accept cash contributions made between March 27, 2020, and December 31, 2020, resulting from the trust experiencing financial hardship due to the COVID-19 emergency. However, the cash contribution must be needed to increase permitted trust reserves, to maintain trust property, to fulfil obligations under mortgage loans, or to fulfil obligations under real property leases.
In addition, a cash contribution from one or more new trust interest holders to acquire a trust interest or a non-pro rata cash contribution from one or more current trust interest holders must be treated as a taxable purchase and sale in accordance with each non-contributing (or lesser contributing) trust interest holder’s proportionate interest in the trust’s assets.
– Lease modification
It can be said that the entire passage of Rev. Proc. 2020-34 is caused by the grave concerns of the missed or delayed rent payments arisen from the leases between the DSTs and tenants. A massive number of tenants are facing income problems due to the weak market demand. In normal circumstances, DSTs, as property owners, can evict defaulted renters. However, the scale of impact of COVID-19 we are facing is unprecedented. Many states have issued executive orders prohibiting landlords from evicting non-paying tenants. The chain reaction of those orders leads to the operational crisis of DSTs since they are suffering from the reduced cash flow. Therefore, there is an impetus from both sides, the DSTs and the tenants, to modify the lease terms in order to accommodate the situation. As a result, Rev. Proc. 2020-34 offers interim permission to allow DSTs to amend their real property leases with the tenants. However, such leases must have been entered into by the trust on or before March 13, 2020, and the modifications must have been requested and agreed to on or after March 27, 2020, and on or before December 31, 2020. Furthermore, the grounds for the modification must be either to coordinate the lease cash flows with the cash flows that result from one or more transactions, or to defer or waive one or more tenants’ rental payments for any period between March 27, 2020, and December 31, 2020 (and all related modifications), if the tenants are experiencing financial hardship due to the COVID-19 emergency.
In sum, the economic crisis triggered by the pandemic threatens the livelihood of DST. Without government intervention, many DSTs would lose their investment trust status, which enables the investors to defer paying their capital gains tax. The Rev. Proc. 2020-34 is the direct regulation to those issues by providing multiple desperately needed temporary solutions to accommodate the financial reality that both DST and tenants are currently facing.