Owners of appreciated real estate face tough decisions: (1) hold onto a property that may not be working for them anymore so they don’t have to pay the high tax liabilities associated with selling; (2) sell and pay the capital gains, 25% depreciation recapture and possibly the 3.8% Net Investment Income Tax; or (3) complete a 1031 exchange, defer the gain and reinvest all proceeds into more desirable replacement property. For those investors exchanging, they can buy traditional fee interest in property or an investment vehicle known as a Delaware Statutory Trust (DST). Regardless, all of the 1031 exchange rules and timelines remain the sale. The DST is simply a different replacement property option.
A DST is a structure permitted under Revenue Procedure 2004-86 and is designed to allow investors to acquire a fractional or beneficial interest in commercial real estate, usually as replacement property in a 1031 exchange. The DST is a grantor Delaware trust that allows individual investors to acquire a beneficial interest. The DST will hold, manage and operate the properties for a profit for the benefit of the DST’s beneficial interests. Each investor will receive their share of the profits, depreciation and gain or loss to report on their individual tax return.
The DST can own one property or a portfolio of properties, usually all within the same asset class, such as multi-family or drugstores, and the investor can invest as little as $100,000 to acquire a fractional interest. Properties can be located anywhere in the U.S., but the trust will be structured under Delaware laws. They provide investors access to institutional grade commercial real estate that is usually only accessible to insurance companies, pension funds and endowments.
A DST is not the right solution for all investors and only accredited investors can invest in one. An accredited investor has to have a minimum annual income or net wealth either individually or with a spouse. Despite being treated as real estate for 1031 exchange purposes, DSTs are sold as a security. A DST sponsor is a company that sets up the DST, buys the property, develops the investment strategy and packages the DST for sale. A DST broker dealer is a securities company that markets DSTs either directly or through its registered representatives. The registered rep will analyze the available DSTs offered through all sponsors and help the investor decide which DST, if any, is a good, long-term solution.
DSTs are professionally managed, usually by the sponsor, and can be a good passive investment for investors looking to retire from being a landlord and the traditional management responsibilities. They can provide current, predictable and steady cash flow. Your debt can also be replaced with pre-existing financing secured by the DST and the debt is non-recourse. Additionally, the investor is shielded from any liabilities related to the property.
DSTs are a long-term investment and usually structured to hold the underlying real estate for 5 – 8 years but depending on market conditions could be more or less time. When the DST decides to sell or “go full cycle,” the gain is prorated between the individual investors and each can decide to exchange into another DST or traditional real estate or cash out and pay the tax.
Another advantage of DSTs is the ability to diversify your real estate portfolio. For example, if you have to buy replacement property for at least $500,000, you could split your exchange funds into multiple DSTs made up of different asset classes and/or in different geographic areas.
A DST is not just advantageous when the Exchanger is looking for replacement property that is easier to manage. There are a number of situations when DSTs can be beneficial:
- DSTs can be a great solution when you cannot find desirable replacement property and your 45-Day Identification deadline is quickly approaching.
- There are usually multiple DST offerings available and they can be identified the same day.
- Most DSTs close very quickly so you can wrap up your exchange swiftly.
- DSTs provide a great backup when you are only identifying one replacement property and you want to give yourself a fallback in case your deal falls through. Once the 45-Day Identification Period ends, you cannot change your identification.
- If your desired replacement property is less expensive than your relinquished property and you need to buy additional property to maximize the benefits of the 1031 exchange, you can identify a DST to make up the difference.
The benefits of a DST might just be enough to consider putting that appreciated property on the market.