Rental property owners often seek the dual financial benefits of receiving a passive income stream while their investment property appreciates. The trouble is you have to work pretty hard for that “passive” income. Owning property requires a significant amount of time, as well as mental and emotional energy. As an owner, you have to find good tenants, negotiate leases, collect rent and deal with delinquencies, maintain and repair the property, and track income and expenses for tax reporting.
All that is on top of finding good property in the first place—either by yourself or with the help of real estate brokers—putting financing in place, and refinancing property loans from time to time. Recent events and legislation strengthening tenant rights have only further complicated property management.
At some point you might conclude it’s too much work and decide to look for other options. Wouldn’t it be nice instead to just get a check in the mail (or even better, a direct deposit to your bank account) and not have to worry about all the other hassles of managing property? Especially if you could do that without paying capital gains tax?
Accredited investors have that option, using an approach that many real estate investors aren’t aware of: Delaware statutory trusts (DSTs).
By selling their current property and completing a 1031 tax-deferred exchange into a DST, accredited investors can defer capital gains tax and own a fractional interest in a professionally managed single property or portfolio of properties.
Accredited investors are investors who have a net worth of $1 million, either alone or together with a spouse or spousal equivalent (excluding the value of the primary residence), or who have income that exceeds $200,000 per year alone or $300,000 per year together with a spouse or spousal equivalent.
Delaware Statutory Trusts
A DST is a separate legal entity set up as a trust for business purposes under the laws of the state of Delaware. It allows multiple investors to co-invest to buy commercial real estate. Each investor purchases a beneficial interest in the trust, which gives them proportional ownership of the commercial real estate assets held in the trust.
DSTs are created and managed by a sponsor, which are typically large commercial real estate investment firms such as Inland, Capital Square, and ExchangeRight. DST investments are offered by sponsors through licensed securities brokers and investment advisors.
DSTs and 1031 Exchange
Most real estate investors are aware of Internal Revenue Code Section 1031, which since 1921 (now over 100 years!) has allowed taxpayers to exchange investment or business-use assets for other like-kind investment or business-use assets without having to recognize capital gain on the sale.
Real estate investors commonly use 1031 tax-deferred exchanges when selling property and buying new property to defer any capital gain. All 1031 exchanges are conducted using a Qualified Intermediary such as IPX1031 and are subject to strict rules for identifying replacement property (within 45 days of sale) and completing an exchange transaction (within 180 days of sale).
An important regulatory change in 2004 clarified that DSTs could be used by investors as replacement property for their 1031 transactions. The Internal Revenue Service (IRS) detailed this change in Revenue Ruling 2004-86, which provided formal guidance about fractional-ownership exchanges and replacement properties.
The revenue ruling contained very specific restrictions on the way DSTs must be structured in order for taxpayers to defer capital gain when investing in them. As a result, DST sponsors must be careful to maintain the proper structure. Investors should be certain that DST sponsors they invest with understand the revenue ruling and have experience in maintaining compliance. Otherwise, your property sale could become taxable.
Attractive Features of DSTs
DST investments can be attractive for several reasons:
Qualify for 1031 exchange—DSTs can be used as replacement property in a 1031 tax-deferred exchange to postpone tax on the sale of appreciated property.
Mailbox money—DSTs deliver truly passive income with monthly checks or direct deposits to investors for their pro rata share of net income from the property or properties in the DST. No more phone calls about problems. You can travel worry-free and truly enjoy peace of mind.
Institutional-quality real estate—DSTs invest in large, institutional-quality properties that are beyond the reach of most investors alone. The properties are researched extensively prior to purchase by professional commercial real estate investors, and they are managed after purchase by professional commercial real estate managers.
Diversification—DSTs invest in single properties or groups of properties across the full spectrum of commercial real estate, including multifamily residential (apartments), single-family residential home communities, grocery stores, retail stores, public storage, data centers, office buildings, industrial buildings, and manufactured home communities (mobile home parks). Investors can use multiple DSTs to create real estate portfolios diversified by type of real estate and geography.
Limited personal liability—Because of the trust structure, owners of beneficial interests in DSTs are shielded from personal liability. Loans on commercial property are secured by the property and not investors’ assets.
In practice, due to the strict IRS requirements for the structure of DSTs, sponsors prepare detailed cash flow projections as part of their due diligence before acquiring properties in a DST. For example, IRS rules do not allow additional capital contributions once the DST offering is closed. Therefore, sponsors must anticipate future cash flow needs and maintain healthy cash reserves.
As a consequence, monthly net profit distributions tend to be more regular than many real estate investors are accustomed to. Historically, investment rates of return have varied by vintage and have been typical for the type of real estate in the DST.
Investment Considerations
As with all investments, there are many issues investors should consider before investing. A few of the unique issues around DSTs that investors should be aware of include:
Minimum investment amount—DSTs typically have a minimum investment amount of $50,000 or $100,000. This is fairly low for private market investments and allows investors to purchase multiple DSTs to build diversified portfolios.
No liquidity—Another strict IRS requirement for the structure of DSTs is that sponsors are not allowed to refinance loans used to acquire properties. For that reason, most DSTs plan to hold properties for five to eight years, at which point the property is sold and the DST is terminated. DSTs are completely illiquid investments—investors should plan on having their money locked up for the entire hold period of five to eight years, and sometimes longer depending on real estate market conditions at the end of the hold period. At termination of the DST, the most basic options for investors are to (1) take a distribution from the DST and pay income tax on their deferred capital gain or (2) invest in new DSTs (or other directly owned property) and continue deferring their investment gain.
Leverage—Most DSTs in the market today use about 50% debt financing to acquire properties in the trust. Investors need to be aware of the amount of debt they carry on the property they are exchanging out of and potential tax consequences if the debt ratio of the DST does not match. DSTs are available that are 100% equity financed.
Availability—The supply of DSTs varies. Most sponsors have only one or a few DST offerings open at any one time. Not all types of property may be available when your 45-day 1031 exchange property identification window is open. Demand for DSTs also shifts and can impact your ability to invest as much as you would like. For example, during the early part of the COVID-19 pandemic, demand was high for essential business property, such as grocery stores, and new construction multifamily residential properties, leading to oversubscribed offerings and limited availability for investors.
Fees and expenses—The structure of DSTs is expensive to operate, and fees can seem high, particularly if your reference point is publicly traded real estate investment trust (REIT) index funds. DSTs are typically offered on a commission basis through brokerage firms; however, sponsors offer a credit to investors working with a registered investment advisory (RIA) firm.
Investment risk—No list of investment issues would be complete without mentioning the obvious risk that sponsors must select good properties to purchase in a DST. Property selection is critical to earning market rates of return or better. Investors should review sponsor-provided due diligence materials thoroughly and carefully.
Complexity—The DST structure is complex and due diligence materials provided by sponsors are typically detailed, including market analyses, property appraisals, leases, rent rolls, historical financial statements, environmental impact reports, and more. Private placement memorandums for DST offerings are often several hundred pages long, with several hundred pages more of attachments and exhibits. Also, like many other private market investments, the paperwork required to invest is complicated, particularly if the investor is an irrevocable trust or limited liability company.
For many commercial and residential rental property owners, DSTs offer an attractive alternative to maintaining investment in real estate, without the daily work of managing a business. With healthy appreciation in real estate assets over the past decade, many investors with substantial gain in their properties will qualify as accredited investors and can use a 1031 exchange into DSTs to delay paying tax. Real estate investors who have a relationship with a financial advisor may want to investigate this option by working with their advisor to identify and review DST sponsors’ currently available offerings.
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