A Complete Guide to DSTs and 1031 Exchanges
A 1031 exchange is an IRS-recognized tax deferral strategy that allows an investor to sell an investment property and acquire a similar property with the intent to defer capital gains and depreciation recapture taxes.
The transaction is named for Internal Revenue Code §1031, which states:
““No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.””Internal Revenue Code §1031
1031 exchanges can be structured through Delaware Statutory Trusts (DSTs), investment vehicles that are used to hold commercial real estate assets. DSTs can offer accredited investors an effective real estate investment solution with a number of potential benefits.
DELAWARE STATUTORY TRUSTS
What is a Delaware Statutory Trust (DST)?
A Delaware Statutory Trust (DST) is a legal entity created under Delaware law as a trust that holds title to 100% of the interest in real property.
Investors acquire a beneficial interest in the trust, with limited personal liability for the underlying assets. DSTs differ from Tenancy in Commons (TICs), another 1031 Exchange fractional ownership strategy, in that each investor does not own a fractional, undivided interest in a property as a co-owner. Therefore, DST investors are not required to share the associated costs of ownership, or be considered “tenants in common.”
With a DST, investors must keep the following things in mind regarding control and liability on the assets in the exchange:
Investors need to assure that the sponsor will be compliant with IRS guidelines
Investors will forfeit all voting rights for decision making to Trust manager
Investors will incur no additional LLC costs
Investors will be limited on liability to invested equity
Investors will not personally assume liability for property-level debt
Investors will own a beneficial interest in the trust
Objectives of 1031 DST Exchanges
A 1031 exchange is an IRS-recognized tax deferral strategy that allows an investor to sell an investment property and acquire a similar property with the intent to defer capital gains and depreciation recapture taxes. More investors are expected to seek a tax-deferred solution with respect to the sale of real property since tax rates increased on capital gains in 2013.
Potentially tax-efficient, non-correlating income
Potential capital appreciation
Access to quality real estate through fractional ownership
The Process: Investing in DST Exchange Trust Properties
With a 1031 exchange, investors can choose between whole-property purchases and fractionally-owned purchases. One advantage of fractional ownership interest in commercial assets that can be an attractive alternative to purchasing a wholly-owned property is the ability to close within the short 180-day time limit and passive ownership (investor is not actively operating the property).
The investor enters into an agreement with a qualified intermediary who facilitates a property exchange.
The investor sells the relinquished property to a third-party buyer.
Sale proceeds are transferred to the qualified intermediary.
The qualified intermediary uses the proceeds to purchase the replacement property on behalf of the investor within the time limits defined in the Internal Revenue code.
Upon closing, the investor owns the replacement property or a fractional interest in a trust that owns the replacement property.
Day 0: Close of Property
Day 45: Identification Period
180 Days: Maximum Time to Complete
BENEFITS AND RISKS
Potential Benefits of a Delaware Statutory Trust
With varied benefits of ownership through trusts, DSTs have become increasingly popular for executing 1031 exchanges. Here are a few potential benefits:
- No personal loan recourse for investors on property-level debt
- Lower minimum investment
- Potential for multi-property diversification
- Multiple, more flexible, exit strategies
Potential Risks of a Delaware Statutory Trust
Along with the benefits, investors should be aware of several potential risks associated with DST exchange programs. Here are a few potential risks:
- Limited transferability, lack of liquidity and less control over operating decisions for individual investors
- If the trustee violates one of the mandatory tax restrictions, investor income could become immediately taxable
- The tax code could change, negatively impacting the tax deferment