United States: Rev. Proc. 2020-34 - Relief for DSTs amid the COVID-19 pandemic

In brief

On 4 June 2020, the IRS released Rev. Proc. 2020-34 which provides three limited safe harbors allowing otherwise Rev. Rul. 2004-86 and Treas. Reg. § 301.7701-4(c) compliant Delaware Statutory Trusts ('DST') structured for use in Section 1031 like-kind exchanges to make certain modifications to their mortgage loans or lease agreements, or to accept certain additional cash contributions; without jeopardizing their federal income tax status as grantor trusts.  
In particular, the revenue procedure provides that such modifications or contributions are not treated as “manifesting a power to vary” the investment of the certificate holders, an action that would otherwise jeopardize the favorable tax treatment of the DST under the requirements of Rev. Rul. 2004-86 and Treas. Reg. § 301.7701-4(c) for qualification as replacement or relinquished property under Code Section 1031.


The ability to utilize such safe harbors is limited to: (i) certain mortgage loan modifications requested or agreed to between 27 March 2020 and 31 December 2020, (ii) for leases entered into by the applicable DST on or before 13 March 2020, certain lease modifications requested and agreed to on or after 27 March 2020, and on or before 31 December 2020, and (iii) the acceptance of certain cash contributions from new or existing interest holder between 27 March 2020 and 31 December 2020.  In addition, the language of the revenue procedure limits the utilization of safe harbors and additional cash contributions to DSTs that have experienced financial hardship (including indirectly due to tenants’ financial hardship in the case of the lease modification safe harbor) due to the ongoing Coronavirus Disease 2019 ('COVID-19') pandemic and have undertaken such modifications or contributions as a result thereof. 

Federal Response to COVID-19

In the nascent period of the COVID-19 pandemic, the U.S. Federal government provided broad relief  to taxpayers when, on 13 March 2020, the President of the United States  issued an emergency declaration under the Robert T. Stafford Disaster Relief and Emergency Assistance Act in response to the ongoing COVID-19 pandemic.  The Emergency Declaration instructed the Treasury “to provide relief from tax deadlines to Americans who have been adversely affected by the COVID-19 emergency, as appropriate, culminating in the enactment of the Coronavirus, Aid, Relief, and Economic Security Act, Pub. L. No. 116-136, 134 Stat. 281" (the 'CARES Act'). 

As the COVID-19 pandemic progressed, the Treasury turned its attention to more nuanced implications of the COVID-19 pandemic.  On 14 April 2020, members of the Baker McKenzie’s North American Tax Practice Group, in partnership with other practitioners, wrote the IRS with respect to the DST real estate investment industry, requesting the IRS to provide emergency relief to certain DST that own real property.  The letter urged that, given the unprecedented economic crisis facing the United States resulting from the COVID-19 pandemic, many of the properties owned by DSTs are facing an operational crisis.  While the challenges facing DST property owners are no different from those faced by other owners, DSTs are at a distinct disadvantage with respect to their ability to adjust to the current economic climate.  In order to allow DSTs the ability to protect the investments of the beneficial owners, the letter requested that the IRS allow DSTs the right to undertake on a temporary basis, certain actions otherwise prohibited under Rev. Rul. 2004-86, including certain loan modifications, lease modifications, and acceptance of additional capital contributions.

Discussion of Rev. Proc. 2020-34

In response to this letter and similar comments from industry participants, the IRS and Treasury acted in response to the financial difficulties from the COVID-19 pandemic faced by impacted taxpayers, and issued Rev. Proc. 2020-34 to provide relief for trustees, commercial and residential tenants, lenders, and investors.  The revenue procedure provides for the following three safe harbors: 

Lease Modification

Leases are generally structured in one of two ways under a DST.  First, if the property acquired is subject to a long-term net lease with a single commercial tenant, the DST will assume the lease with the tenant. If there is more than one tenant, the DST will frequently enter into a master lease arrangement with an affiliate of the DST sponsor, and the master tenant will sublease the property. Rev. Rul. 2004-86 states that the DST is prohibited from renegotiating its lease or entering into new leases, except in the case of the tenant’s bankruptcy or insolvency.  The identity of the applicable tenant for purposes of this exception depends upon whether or not the DST utilizes a master lease, as discussed above.  In the absence of a safe harbor, execution of a prohibited lease modification or re-leasing could cause the DST to lose its tax status as an investment trust, negatively impacting the ability of interest holders to use the DST in connection with a section 1031 like-kind exchange.

The COVID-19 pandemic has caused many commercial tenants to suffer a reduction in their cash flow, making it hard for many to remain current with their rent payments.  This has led many tenants to ask for a modification on their lease in order to avoid default.  Furthermore, the COVID-19 pandemic has caused widespread unemployment, causing many residential tenants to miss or delay their rent payments, especially since many states have issued orders prohibiting landlords from evicting non-paying tenants. The prohibition on lease modification has placed many DSTs and master tenants in a precarious position, as they are locked into underperforming but unchangeable leases but remain obligated to make full payment on their loan and rent obligations.

Under Rev. Proc. 2020-34, DSTs can modify a real property lease that they had entered before 13 March 2020.  The lease can be modified to (i) coordinate the lease cash flows with the cash flows that result from a qualified forbearance (discussed below), or (ii) defer or waive one or more tenants’ rental payments for any period between 27 March 2020 and 31 December 2020.  In order to qualify for these modifications, two requirements must be met: (i) the modification were requested and agreed to by the DST and tenants between 27 March 2020 and 31 December 2020, and (ii) the tenants must be experiencing financial hardship due to the COVID-19 pandemic.  Any modifications and amendments to a lease under Rev. Proc. 2020-34 must be given appropriate tax effect under the applicable provisions of the Code and regulations, including the provisions in Treas. Reg. § 1.467-1(f) relating to substantial modifications of section 467 rental agreements.

The lease modification safe harbor provides flexibility to allow DSTs to better prepare for the economic realities of this pandemic, and help tenants remain economically viable during the COVID-19 pandemic. Because of this safe harbor, DSTs will be able to receive partial rent payments instead of foregoing the entire amount, allowing both tenant and DST to come out of this pandemic in a stronger economic standing than they would have otherwise, while protecting DST interest holders’ Section 1031 status.

Loan Modification

The COVID-19 pandemic has caused many borrowers to struggle staying current with their loan payments, including many DSTs.  In order to avoid a foreclosure crisis, such as the one in 2009, lenders have shown a willingness to work with borrowers to modify the terms of their debt.  However, under Rev. Rul. 2004-86, DSTs are prohibited from renegotiating the terms of the debt used to acquire the property owned by the DST.  This prohibition would generally not allow DSTs to take advantage of the modifications being offered by lenders, but the safe harbor under Rev. Proc. 2020-34 relaxes this prohibition under specific circumstances.

Rev. Proc. 2020-34 allows qualifying DSTs to modify a mortgage loan securing the DST’s property by entering into a qualified forbearance program.  The qualified forbearance program may fall under two categories: (i) a forbearance program being granted under the CARES Act; or (ii) a similar forbearance program of up to six months being provided to trusts experiencing financial hardship due to the COVID-19 pandemic and which was requested and agreed to between 27 March 2020 and 31 December 2020.

The loan modification safe harbor allows DSTs facing financial hardship to remain economically viable by modifying their loans, protecting lenders and DST interest holders.

Additional Cash Contributions

Rev. Rul. 2004-86 prohibits DSTs seeking investment trust treatment from accepting additional contributions of assets (including money).  This prohibition makes DSTs particularly vulnerable to drastic changes in the economy that reduce rents produced by properties owned by the DST.  Because additional cash contributions are prohibited, the DST has to continue paying its expenses with a reduced cash flow with no option for supplemental addition to capital. Furthermore, some lenders may only consider a loan modification if the borrower contributes additional capital, which could have prevented DSTs from entering into loan modifications, but for the additional cash contribution safe harbor.

Under Rev. Proc. 2020-34 a DST is allowed to accept cash contributions that are made between 27 March 2020 and 31 December 2020 as a result of the DST experiencing financial hardship due to the COVID-19 pandemic. In order to qualify, the contribution must be provided to (i) increase permitted trust reserves, (ii) maintain trust property, (iii) fulfill mortgage loan obligations, or (iv) fulfill real property lease obligations.  Furthermore, if the contribution is made by new interest holders or is a non-pro rata contribution made by an existing interest holder, it will be treated as a taxable sale by each non-contributing interest holder of his proportionate interest in the DST’s assets.

The additional cash contributions safe harbor creates optionality for a DST and its interest holders to decide if the investment is worth an additional contribution or to let the investment fail, instead of letting the COVID-19 pandemic decide for them.

The requirements under Rev. Rul. 2004-86 are too stringent for the economic conditions we are facing today.  Rev. Proc. 2020-34 has eased those requirements and has allowed DSTs and their interest holders to face this unprecedented situation in a much stronger position than they would have otherwise.


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