A-to-Z Guide to Delaware Statutory Trust (DST) 1031 Exchange
**The information on this web page is provided for informational purposes only and should not be considered as legal, tax, financial or investment advice. Since each individual’s situation is unique, a qualified professional should be consulted before making financial decisions.**
Are you thinking about exchanging real estate investment property? There are dozens of good reasons to consider a Delaware Statutory Trust 1031 Exchange.
- sharing interest in institutional-grade properties with as little as $25,000,
- purchasing partial interests in multiple properties to diversify,
- consolidating many properties into fewer ones and
- jettisoning property management drudgeries.
At the same time, you can defer capital gains and other taxes with a DST 1031 Exchange.
We’ll explain it all starting with a brief 1031 Exchange overview. Read on.
What Is a DST 1031 Exchange?
1031 Exchanges Overview
Internal Revenue Bulletin: 2004 ignited investor and Sponsor interest in utilizing these trusts. Sponsors are either individuals or firms marketing real estate services and products including fractional interests in DSTs they’ve created.
This ruling solidified DSTs’ eligibility for Section 1031 tax deferrals with holdings that read:
- The Delaware statutory trust described above is an investment trust, under § 301.7701-4(c), that will be classified as a trust for federal tax purposes.
- A taxpayer may exchange real property for an interest in the Delaware statutory trust described above without recognition of gain or loss under § 1031, if the other requirements of § 1031 are satisfied. [emphasis added]
This Bulletin validated a clear path for deferring capital gains and other taxes on your relinquished property. Since DSTs are federally recognized, Sponsor may act on your behalf in 1031 Exchanges. They’re involved in closings on interests being purchased in DSTs they own.
For the unfamiliar, 1031 Exchange process and timeline are regulated by rather complex rules. In short, after deciding to sell (relinquish) investment property, you seek a buyer for the asset(s) to be sold.
With a successful sale, the 1031 clock starts on identifying replacement(s) (learn more about the 45-Day Period and Other 1031 Exchange Property Identification Rules). It’s the first of two irrevocable deadlines outlined in this chart.
This Exchange is a very structured, unforgiving process. However, since DSTs are holding replacement(s) and go to closing for you, meeting these deadlines is made much easier for you and your 1031 exchange company (Qualified Intermediary).
Simply put, after selling relinquished property, typically the DST Sponsor works the closing process on replacement(s) with your Qualified Intermediary (aka 1031 exchange accommodator or facilitator).
Near best of worlds? You are:
- utilizing IRS-endorsed DST 1031 Exchanges to defer taxes,
- obtaining an interest in secure, high-quality property, and
- if you ever had tenants, gaining freedom from the terrible Ts, i.e. toilets, trash and taxes.
You’re a passive investor! By exchanging your property into a DST, you are doing a 1031 exchange into a REIT (Real Estate Investment Trust). In REITs sponsors, their appointed Trustees, and outsourced management contractors assume landlord duties. They’ll collect the rent, maintain the property, respond to tenant concerns, et al.
These services are a big DST selling points. Yet they’re sometimes seen negatively, potentially allowing things to run amok absent your input. A lot depends on your confidence in the Sponsor. With your or a tax advisor’s careful due diligence, a highly-rated Sponsor is golden.
Delaware Statutory Trust Explained
A DST is a real estate investment entity not unlike a limited liability company (LLC) or partnership in some respects. A pass-through entity, all income and dividends are taxed at the investor level.
It’s designed to permit large numbers of investors to own fractional interests in large real estate holdings. It’s easy to see the import of IRS’ 2004 recognition of DST’s property as 1031 Exchange qualified. One would expect other types of trusts would be competing with the DST for market shared.
Why Delaware Statutory Trusts Dominate the Market
It’s not an accident. As a matter of public policy, Delaware has been determined to lead the country in fiduciary and financial service. Most states rely on common law trust rules, i.e. uncodified rules for creating trusts. No surprise this causes much uncertainty.
Delaware is an exception with Delaware Statutory Trusts governed under comprehensive provisions of Title 12 Certificate of Trusts. These provisions along with IRS’ 1031 Exchange approval have propelled DSTs’ popularity. Title 12 provides legally enforceable trust rules ready-made as a foundation and framework for the DST.
Particularly pertinent here are Section 3805 declaring your rights as beneficiary:
Rights of beneficial owners and trustees in trust property provides for the creation of several classes of trustees and beneficial owners. That determines assets distributions to beneficial owners …
and §3806 providing for organizational structure:
Title 12 §3806: Management of statutory trust delegates powers to the Trustees. They in turn may re-delegate some of those duties to officers, agents or others designated in the Agreement.
Further, the 1985 Direct Trustee Statute allows Sponsor-appointed trustees to work with outside investment advisors and other trust specialists. A Directed trustee may engage independent investment and distribution advisors to provide investment, logistic, and other support.
Further, investors are offered a high degree of comfort under enforceable Trust legal oversight. The Directed trustee may engage trust protection advisors, as well. Since DSTs are a pre-packaged investment, it also means due diligence examinations have been performed by the Sponsor. All property inspections have been conducted as well.
What to Expect from DST Sponsors
Typically, Sponsors first create these pre-packaged 1031 Exchange into Delaware Statutory Trust containers with an eye to attracting investors. They orchestrate all the day-to-day operations. Further, lenders make loans directly to DST Sponsors, not separate ones to each investor. As such, the DST directly owns the assets while trust shares are owned by individual investors.
Real estate Sponsors tailor DST 1031 investments targeting different investor demands, such as:
- minimal property management headaches, i.e. passive investing,
- a steady income stream,
- major property appreciation potential,
- low investment risk, or
- two or more of the above attributes.
Sponsors install management teams to conduct day-to-day operations. They outsource maintenance-related services. Pre-defined and legally enforceable by statute, these rules provide the necessary safeguards for you to comfortably escape the managerial fray as a passive investor.
With necessary due diligence taken in selecting a Sponsor, most investors find DTS rules provide an adequate level of safety. Unlike partnerships, LLCs, or Tenants In Common (TIC), there’s no potential confusion or internal struggles over operations or earnings distributions.
Just greater focus on earnings.
Unlike after doing a 1031 exchange into a TIC (Tenants in Common) property, you as a DST investor have no vote. You’re without any say over daily operations. That’s understood but the DST’s goal is a net positive trade-off, i.e. giving up managerial control for a secure yet hassle-free investment.
Often there’s another sponsor-directed efficiency. Many DST properties are office or retail rentals operating under a net lease. Under a Triple Net Lease (NNN), tenants pay some or all taxes, maintenance, and other costs. With a Double Net Lease property taxes and insurance are paid while in a Single Net Lease it’s just property taxes.
Rent is paid by the tenant in all cases. These leases reduce risk and administrative expenses for investors.
Pros and Cons of a 1031 Exchange into DST
24 Pros of a 1031 Exchange into DST
- The U.S. Chamber of Commerce ranks Delaware’s Chancery Court among the country’s best. It has exclusive jurisdiction over trust cases. It’s a major contributor to resolving legal disputes equitably and without delay.
- DSTs don’t generally limit investor numbers. Sponsors do sometimes set a limit they consider manageable. Cash investment minimum as low as $25,000 are possible although 1031 Exchanges often have a $100,000 minimum.
- With this low investment dollar threshold you’re able to share interest in institutional-grade properties, and as a tenant, throughout many industries and locations.
- Wanting to move property, you can replace current property with a replacement in another locale, but only within the United States.
- You’re able to purchase partial interests in multiple properties. Particularly so if you presently own a large property that can be exchanged for multiple replacements.
- Conversely, you can choose to consolidate several smaller assets into a larger commercial holding. Many investors e.g. choose to exchange multiple rentals for one commercial property.
- Since DSTs are a pre-packaged investment, due diligence examinations have been performed by the Sponsor. All property inspections have been conducted pre-sale as well.
- Property management responsibilities are assumed by the DST Sponsor. A Directed trustee may retain third-party financial and asset protect advisors. An outside management team carries out day-to-day property upkeep tasks.
- Having no vote removes the possibility of dissension or other distractions from hindering the work of professional consultants. With a single trustee (Sponsor) in control, there’s no contending with other investors over sometimes contentious investment issues.
- With 1031 Exchanges, the often high-stress process of identifying replacement(s); negotiating/financing property acquisitions; and replacement closings are eliminated. Sponsors work to close on replacement(s) that the DST is holding.
- Generally, there are no closing costs often associated with a TIC on its single member LLC acquisition for asset protection.
- All DST-held investment or business property qualifies as like-kind in 1031 Exchanges. On sale of DST property, you’re allowed endless future DST 1031 Exchanges with continued tax deferral.
- Never selling, at death the asset basis is reset and potentially no gains or depreciation recapture taxes imposed for years or potentially never.
- As a pass-through entity, your annual depreciation expense write-off on existing property may be largely depleted. Replacement(s) can rejuvenate that expense deduction.
- Cash flows (generally received monthly) are increased should you be exchanging low- or non-performing real estate for more cash receipts.
- In addition to monthly cash considerations, on termination of the DST you’ll receive full property appreciation and gains from principal paydown.
- To avoid taxable 1031 exchange boot, the rules require all relinquished property equity be expended on replacement(s). A DST 1031 Exchange makes it easier to locate replacement property matching or exceeding equity needs.
- In a partial 1031 Exchange, the unused exchange funds can be invested in a DST, again to avoid boot.
- Liability is limited to the amount of your investment. Potential creditors are limited by trust provision from reaching other assets beyond your investment.
- Lenders make just one loan to DST sponsors, thereby precluding confusion and any internal dissention sometimes associated with Tenants In Common.
- To reduce financing risks, properties serve as the collateral for loans in most DST 1031 investments.
- Collateral danger possibly caused by unscrupulous investor(s) in a Tenants In Common ownership is avoided.
- Environmental damages and investor fraud carve-outs are carried out by DST trustees. DST investors are not personally liable for the repayment of non-recourse loans.
- Trust-derived income received by non-residents is not subjected to Delaware income tax.
7 Cons of a 1031 Exchange into DST
- Only accredited investors can participate in Delaware Statutory Trusts. This puts direct participation out of reach for many investors. The term accredited investor is defined in Rule 501 of Regulation D of the U.S. Securities and Exchange Commission (SEC).
- Not unlike other real estate investments, DST properties are classified as illiquid. Not generally easy to sell, DSTs are long-term investments. Estimated investment periods are between five and ten years.
- Control is lacking in what happens to the property, which is seen as both a curse and blessing. If the sponsor has contracted with a highly competent management team, on balance unhelpful interference is likely to outweigh the value of any investor input.
- There’s inherent risk, however, in relying upon Sponsors and their continued competency and success. Associated risks include awarding to a third-party complete discretion for managing, leasing and property sales. There’s always the potential for conflict of interest among Sponsors and their self-appointed teams.
- Once closed, a DST cannot receive more contributions or renegotiate existing loans. If the property needs additional capital for maintenance of other expenditures, e.g. it comes out of the profits you’ve earned in the past.
- Real estate frequently provides investors with appreciation growth. DST regulations may limit property acquisitions to non-speculative assets. Such assets while safe and perhaps good cash flow performers, typically don’t appreciate rapidly.
- DSTs are typically sold through broker-dealers who often charge high commission rates. With legal fees added, your ROI takes a hit.
Your First Step to a DST 1031 Exchange
You’ll need a securities broker/dealer to access DST property. Further, many brokers can only offer DST properties to accredited investors.
Deciding on the type of property to purchase depends primarily on your objectives. For example, where do risk and rate of return rank for you? Apartment buildings and condos are usually rated low-risk and accordingly have lower yield expectations. Retail and other commercial properties carry higher risk and expected yield potential.
Yet each investment property is unique and requires examination by a DST property pro. Section 1031 Exchanges alone are complicated and fraught with risk. A broker or other professional can help you formulate specific objectives and then recommend DST products.
PropertyCashin is an all-in-one platform for commercial real estate investors. We maintain relationships with top-rated 1031 exchange firms working with DST in all US locations. To get connected with the best professionals and have your exchange processed safely and effectively, fill out the form below.