The Delaware Statutory Trust, or DST, is an option for accredited investors who wish to have the advantages of owning tax-deferred commercial real estate without the responsibility of personal property management or the strict timing rules of typical 1031 Exchanges.
The Delaware Statutory Trust structure allows real estate ownership by multiple investors who each hold an undivided fractional interest in the holdings of the trust. The trust itself holds the titles to the real properties and the investors hold beneficial interests in the trust.
|Delaware Statutory Trusts for 1031 Exchanges
One of the primary strategies for creating wealth in real estate has always been to buy properties, build equity and then sell and move on to larger properties, expanding the size and scope of one’s real estate holdings. 1031 Exchanges have allowed capital gains to be deferred as investors move on to bigger properties.
A 1031 Exchange refers to Section 1031 of the U.S. Internal Revenue Code. It is a transaction approved by the IRS that allows a real estate investor to defer the tax liability or capital gains taxes on the sale of commercial investment property, as long as the investor identifies a “like-kind” replacement property of equal or greater value within 45 days, and closes on it within 180 days. Equity can be preserved and capital gains taxes can be deferred as long as all IRS rules are followed.
In 1988, the state of Delaware passed the Delaware Statutory Trust Act, which was groundbreaking. In 2004, the IRS issued Revenue Ruling 2004-86, which allowed DSTs to qualify as “replacement property” for the tried-and-true 1031 Exchange. A Delaware Statutory Trust used for a 1031 Exchange can typically close quickly, within three to five business days following the sale of the original property.
How DSTs Work
The DST Sponsor
A national, professional real estate company referred to as a “DST sponsor” identifies, acquires and manages the commercial real estate assets included within each Delaware Statutory Trust they put forward. A DST sponsor typically seeks out institutional-grade properties with good income potential.
Although a Delaware Statutory Trust can own multiple properties, each typically focuses on a single property type. (To diversify across different property types, an accredited investor can invest in multiple DSTs.) The four main types of commercial real estate generally held by a DST are multifamily, office, industrial and retail. Niche property types like senior housing, medical offices and self-storage facilities are also used.
DSTs Are Sold By Investment Brokers
DST investments are typically not marketed directly to the public because of SEC regulations. DSTs are marketed through independent brokers who carry the necessary securities licenses to transact DSTs on behalf of clients.
Who Can Invest in a DST?
You must be an accredited investor, defined by the Securities and Exchange Commission as an individual with a net worth of $1 million (excluding their primary residence) or an average annual income in excess of $200,000 for the last two years ($300,000 for a couple filing jointly).
DST Minimum Investment
Delaware Statutory Trusts typically require a minimum investment of $100,000, and an accredited investor can acquire or exchange into ownership in one or multiple DSTs. DST real estate is generally held for three to 10 years. Upon the sale of the property, the investors receive all sales proceeds, including gains from potential appreciation, which can then be exchanged again to continue deferring tax.
The Potential Benefits
1031 Replacement with Less Timing Restrictions
A Delaware Statutory Trust (DST) is an increasingly popular option as a 1031 Exchange property option for investors who want to keep 1031 Exchange benefits but don’t want to deal with stringent IRS requirements anymore. The burden of identifying, purchasing, and managing the DST property(s) to be structured within the trust are the responsibility of a DST sponsor.
A DST does not require the seller to reinvest in a “like-kind” replacement property. Additionally, a DST is not subject to the tight timeline restrictions of a §1031 exchange.
Access to Institutional-Grade Properties
Using DSTs, 1031 exchange proceeds can be allocated across multiple institutional-grade DST properties that are typically much larger and out of reach of most individual investors.
The large commercial real estate investment properties owned by DSTs with nationally-known, stable retail tenants—with purchase prices ranging from $30 to $100 million—become attainable for smaller real estate accredited investors through the fractional ownership offered by a DST. This gives individual investors an opportunity to acquire passive ownership in an institutional-quality asset with a comparatively low minimum investment cost.
Passive Income Potential and Tax Breaks, Without Landlord Headaches
The DST enables a real estate investor to maintain an investment position in real estate without the personal management responsibilities. If an investor is ready to give up control and effectively outsource all the of the property management, maintenance, reporting and hassles of being a landlord, Delaware Statutory Trusts can offer passive income while retaining all the tax-advantages that come with owning income-producing real estate.
DSTs are pass-through entities, and fractional owners are allowed to participate in depreciation and amortization, meaning that investors are often able to shelter much of their monthly DST income from taxation in the same way commercial real estate owners and landlords can.
The Potential Downsides
It’s Not Available to Everyone
Only accredited investors are allowed to invest in a DST. The biggest challenge of investing in a DST may be in finding one—DST investments are seldom marketed directly to the public because of SEC regulations. DST sponsors work directly with securities broker-dealers and 1031 Exchange advisors to make offerings available to accredited investors.
Like all real estate investments, investing in Delaware Statutory Trusts involves many of the same risks, including potential lack of return and loss of principal. As long-term, income-focused investments, DST performance is largely dependent upon the tenants’ ability to pay rent. You may face lack of liquidity, interest rate risk, and changing or depressed real estate market conditions.
There are underwriting and administrative costs reimbursed to DST sponsors that are incurred by the trust when acquiring real estate, analyzing potential returns/conducting property acquisition due diligence, and structuring the trust legally. These may include loan origination costs and real estate commissions as well as other fees. In addition to these costs, sometimes DST sponsors earn a percentage of net operating income. It’s important to examine your potential DST investment closely and consult with your CPA, attorney, and financial advisor before pursuing.
FOR ADVISOR USE ONLY, NOT FOR USE WITH THE GENERAL PUBLIC
The information provided in this article does not, and is not intended to, constitute legal advice or tax advice. All contents are for general informational purposes only. Readers should contact their attorney and/or accountant to obtain advice with respect to any particular legal or tax matter.
As a CERTIFIED FINANCIAL PLANNER™, former advisor and portfolio manager for one of the nation’s largest wirehouses, Andy understands what it is like to sit across from a client during good times, but more importantly, during bad times when markets are down.