What If a DST Sponsor or Master Tenant Files for Bankruptcy?

Three parties can fail and they are not equally dangerous: the sponsor, its master tenant and the lender behind both

In a master-leased DST the trust owns the building and leases the whole of it to a master tenant that is, in one sponsor's own explainer, generally an affiliate of and controlled by the sponsor, formed as a special-purpose entity and typically only minimally capitalized. The master tenant pays the trust rent set at debt service plus a market return, keeps any operating income above that, and subleases to the actual occupants.

Your distributions are therefore that rent minus debt service and fees, and the sponsor sits in the structure twice: as manager or signatory trustee of the trust and as owner of the master tenant. The lender holds a first lien on the building under a loan that Rev. Rul. 2004-86 describes as nonrecourse to the trust and to its owners.

The failure order matters. A sponsor can fail without the master tenant missing rent; a master tenant can fail while the sponsor survives; and either can trigger loan defaults that put the lender in charge. The lease mechanics themselves are on DST master leases and the risks they add.

If the sponsor itself files, Delaware law keeps the building out of its estate, but you lose the manager and possibly the loan guarantor

Section 3805(g) of the Delaware Statutory Trust Act provides that no creditor of the trustee has any right to obtain possession of, or otherwise exercise remedies against, the property of the trust for claims against the trustee in its individual capacity. Section 3808(b) adds that the bankruptcy of a trustee does not dissolve the trust, and the ruling's own facts assume a trust that will not terminate on the bankruptcy of any owner.

What you do lose is the operator. The sponsor's affiliates usually provide asset management, investor reporting and the master tenant's balance sheet, and the sponsor or its principal is commonly the carve-out guarantor on the loan; a guarantor's bankruptcy is an event of default under many commercial loan agreements, which is why the PPM's loan summary deserves a read for that clause.

Whether beneficial owners can replace the manager depends on the trust agreement; section 3806(b) lets the governing instrument give beneficial owners voting rights on trustee appointments and asset dispositions, but nothing requires it. How to weigh a sponsor's balance sheet before you buy is on evaluating and comparing DST sponsors.

A master tenant's bankruptcy is the case Rev. Rul. 2004-86 anticipated, and the Bankruptcy Code sets the timetable

The ruling's model trust agreement forbids the trustee from renegotiating the lease or leasing to anyone else except in the case of the master tenant's bankruptcy or insolvency. That exception is what lets a trustee install a replacement master tenant, or lease directly to occupants through a property manager, without turning the trust into a partnership.

Inside the case, 11 U.S.C. 365 governs. The debtor must timely perform all obligations under an unexpired lease of nonresidential real property until it assumes or rejects it, must cure defaults to assume, and if it has not assumed within 120 days of the petition the lease is deemed rejected, with one 90-day extension for cause; rejection is treated as a breach as of the petition date.

Your claim for lost rent is then an unsecured claim capped by 11 U.S.C. 502(b)(6) at the greater of one year's rent or 15 percent of the remaining term, not exceeding three years, plus rent already unpaid. Subtenants keep their protection too: section 365(h) lets a lessee whose landlord rejects keep possession for the balance of the term, so the occupants' leases can outlive the master tenant.

• Hypothetical: master rent of $1,000,000 a year with eight years left. Fifteen percent of the term is 1.2 years, so the capped claim is $1,200,000, paid in bankruptcy dollars, while the trustee's real remedy is a new tenant.
• Distribution outlook during the case: base rent may continue if the debtor keeps performing under 365(d)(3), supplemental rent tied to the master tenant's profit usually stops, and reserves bridge the gap only for as long as they last.

The lender comes first, and a cash sweep, default and foreclosure is the path from paused distributions to a wiped-out position

Nothing in either bankruptcy changes the lien. If rent stops and debt service is missed, the loan's cash-management and default provisions run their course, and the trustee cannot cure the problem by refinancing or restructuring because Rev. Rul. 2004-86 lists renegotiating the debt among the powers that would make the trust a business entity.

Foreclosure is a taxable disposition. Reg. 1.1001-2(a)(4)(i) treats the transfer of property securing a nonrecourse loan as discharging the borrower, and the amount realized includes the whole loan regardless of the property's value; Commissioner v. Tufts, 461 U.S. 300 (1983), held that the fair market value of the property is irrelevant to that calculation.

Hypothetically, if your share of the loan is $500,000 and your adjusted basis in the interest is $300,000, a foreclosure produces $200,000 of gain and no cash, on top of the loss of your equity. The leverage side of this is developed on DST leverage and interest-rate risk.

The springing LLC can save the building, and the price is your next 1031

PPMs handle the deadlock with a conversion clause. In the risk-factor language of one offering, if the manager determines that it is necessary to preserve and protect the property, the trust transfers the property to a newly formed Delaware limited liability company; the LLC is treated as a partnership for federal income tax purposes, the beneficial owners become its members, and membership interests are not treated as interests in real property for purposes of section 1031.

The same passage concludes that after such a transfer it is unlikely any of the beneficial owners will be able to defer gain on a later disposition under section 1031, because section 1031(a)(2) excludes partnership interests. The loan stays on the property, distributions may resume, and you have kept the asset at the cost of exchanging out of it later; what an ordinary sale looks like instead is on what happens when a DST sells.

Distress shows up in the reporting months before a filing: shrinking supplemental rent, reserve draws and missed lender tests

Ask for the numbers behind the distribution, not just the rate. A distribution funded from reserves or from the master tenant's security deposit is a warning; FINRA Notice 20-21 requires broker communications to separate operating cash flow from returned principal and borrowed money for exactly that reason, and a sponsor's quarterly report should do the same.

What a healthy reporting package looks like is set out on DST reporting and transparency expectations, and the full risk map is on key risks of DST investments. Because loan covenants and trust agreements differ, confirm the default and conversion clauses in your own documents with your CPA or attorney.

• Base rent paid but supplemental rent gone for two or more quarters, which means the property is no longer covering the master tenant's margin.
• Lender cash-management triggers, debt-service-coverage tests or reserve top-ups mentioned in investor updates.
• Sponsor-level signs: staff departures, delayed grantor letters, guarantor net-worth covenants renegotiated, or other programs from the same sponsor cutting distributions.
• A request to approve a transfer distribution or LLC conversion, which is the last step before the mechanics above.