What are the ins and outs of Delaware Statutory Trusts (DSTs) as an alternative vehicle for 1031 tax-deferred exchanges?
Navigating a successful 1031 exchange can be stressful, given the strict time frames imposed by the IRS for a tax-deferred exchange. Many investors in the middle of 1031 exchanges are turning to Delaware Statutory Trusts (DSTs) as potential replacement property. In this brief overview, we will discuss what a DST is, how it works, its advantages and drawbacks, IRS rules for using a DST in a 1031 exchange, and why it may be a suitable alternative for real estate investors.
What Is A DST, And How Does It Work?
A DST is a fractional ownership structure that investors can use in a 1031 tax-deferred exchange. Since 2004, when a favorable ruling by the IRS allowed the use of them in 1031 exchanges, DSTs have become an alternative vehicle for investors conducting a tax-deferred exchange. Instead of directly owning a property, the investor owns a fractional interest in a property that is institutionally managed by a sponsor. The investor takes a passive role in the property, while the sponsor handles landlord duties and other property management tasks. These sponsors are typically large real estate operators, some of whom manage multibillion-dollar publicly traded real estate investment trusts (REITs).
Advantages Of A DST
Investment-grade real estate opportunities: DSTs provide the ability to own investment-grade real estate, such as class A apartments or long-term net leased properties occupied by national credit tenants.
True passive investment: DSTs offer true passive investment, with the burdens of property management falling on the DST sponsor.
Liability protection: Fractional ownership in a DST helps to shield an investor from potential liability because the property is not owned directly by the investor.
Nonrecourse debt protection: Nonrecourse debt used by the DST provides an additional layer of protection for an investor’s other personal and business assets.
Simplified loans: Loans are made to the DST directly without each investor having to qualify for the loan, and the debt can be directly tailored to the investor’s needs for a 1031 exchange.
Diversification: Multiple properties with varied debt structures may be held within the same DST, providing investors with diversification in the same DST investment vehicle.
Quick closing process: Prepackaged offerings enable an investor to close on a DST investment in a matter of days.
Drawbacks To A DST
Broker expertise: Although FINRA governs brokers creating and marketing DSTs, not all brokers selling DSTs have real estate education, training, or experience.
Limited decision-making power: When a DST is used in a 1031 tax-deferred exchange, major decisions about selling the property, day-to-day property management, refinancing, and capital repairs do not require the consent of the owners/investors.
Real property risks: While non-recourse loans used by a DST to finance property do not require personal investor guarantees, the real property used as loan collateral is at risk should the real estate market suddenly change.
Lack of liquidity: No public market currently exists, and one may never exist, for the interests of any DST program. These programs are speculative and should only be considered by those who have no need for liquidity in their investment and who can afford to lose their entire investment.
Please consult your tax advisor for IRS rules regarding the use of 1031 DST tax-deferred exchanges.
For more insights into the 1031 DST tax-deferred exchange opportunities we offer our clients, we invite you to fill out the information request form. Once received, a member of our team will promptly reach out to you.