Understanding DSTs

February 16, 2024

Tim Clarke

Holding a DST investment property? Execute a 1031 exchange to defer taxes and preserve your capital if you need to relinquish the asset

A Delaware Statutory Trust (DST) is a legal entity that can hold investment real estate on behalf of multiple investors, allowing them to defer capital gains taxes through participation in a 1031 exchange.

DSTs provide access to larger institutional-grade properties with professional management, aiming to give investors stable passive income, portfolio diversification, and built-in exit strategies.

Investors should vet the properties, sponsors, fees structure, and debt terms when evaluating DST offerings, working with financial and legal advisors for guidance on due diligence and suitability.

DSTs appeal to accredited investors seeking turnkey real estate exposure to round out their portfolios, with potential estate planning benefits like a stepped-up tax basis if held until death.

While DST investments can last 4-10 years, offering tax deferral throughout, changing regulations could impact their future viability.

What is a DST?

DSTs are separate legal entities that can hold real estate assets and provide flow-through tax benefits to investors.

They are established under Delaware state law and designed for 1031 tax-deferred exchanges, allowing investors to defer capital gains taxes.

DSTs only hold real property and mortgages, no operating businesses. Investors receive pro-rata shares of income and expenses based on their ownership percentage.

Professional asset managers oversee the properties.

To invest in a DST, investors typically need about $100,000 to buy a share of the entire property investment, spreading money across different buildings instead of just one.

This diversification lowers risk - if one property struggles, others may do better, making the overall investment safer.

DST Structure

The DST operates under a trust agreement, where a trustee oversees the trust's operations on behalf of its beneficiaries (the investors).

The legal structure is such that the DST itself holds title to the real estate, and the investors own shares of the trust.

This structure simplifies ownership and reduces the management burden on individual investors.

DST Returns

Investors in DSTs are often attracted by the potential for regular income distributions, which typically come from the operation or leasing of the property.

Additionally, there's the prospect of appreciation over time.

However, like all investments, DST returns can vary based on several factors including property performance, market conditions, and the skill of the DST sponsor.

1031 DST Sponsors

The role of the DST sponsor is critical. These entities identify, acquire, and manage the property on behalf of the DST.

A reputable sponsor can significantly affect the success of a DST investment.

They are responsible for the underwriting, financing, property acquisition, and ongoing management.

Investors should conduct thorough due diligence on sponsors, considering their track record, expertise, and financial stability.

1031 Exchange into DST

Investors looking to defer capital gains taxes from the sale of a property may consider a 1031 exchange into a DST.

A DST qualifies as "like-kind" property for 1031 exchanges, allowing investors to roll over profits from a real estate sale into a DST without immediate tax implications.

This process must adhere to specific IRS guidelines regarding timing and identification of the replacement property.

Key things to know about DSTs:

  • They are designed for 1031 tax-deferred exchanges, allowing investors to defer capital gains taxes
  • DSTs only hold real property and mortgages, no operating businesses
  • Investors receive pro-rata shares of income and expenses based on ownership percentage
  • Professional asset managers oversee the properties

What is a DST 1031 Property?

A DST (Delaware Statutory Trust) is like a box that holds investment real estate. It's kind of like an LLC (Limited Liability Company). But DSTs have different rules.

DSTs fit into something called a 1031 exchange.

This is a process made by the IRS that lets real estate investors sell a property and use that money to buy another one without paying taxes right away.

The DST counts as swapping one property for a similar one, which is what a 1031 exchange is about.

Joining a DST 1031

To join a DST, you typically need about $100,000. This buys you a share of the whole property investment.

It spreads your money across different buildings instead of just one. This avoids "putting all your eggs in one basket."

Spreading Out Risk

The word "diversify" means spreading investments around to lower risk. By investing in a DST 1031, your money goes into multiple properties instead of just one.

If one property struggles, others may do better. This makes your investment safer overall.

What are the potential benefits of investing in a DST?

DSTs offer investors various tax advantages, including the opportunity to defer capital gains taxes through 1031 exchanges and flow-through depreciation benefits over the investment timeframe.

DSTs also provide investment benefits like access to institutional-grade real estate normally unavailable to individual investors, diversification across larger assets, and professional property management.

Additionally, DSTs offer simplicity through turnkey, pre-determined real estate investments without having to self-manage properties.

DSTs can also include built-in debt, which helps investors reinvest full sale proceeds from a previous property to qualify for tax-deferred 1031 exchanges.

Tax Advantages

  • Opportunity to defer capital gains taxes through a 1031 exchange
  • Flow-through depreciation benefits over the investment time horizon

Investment Benefits

  • Access to institutional-grade real estate normally unavailable to individual investors
  • Diversification across larger real estate assets
  • Professional asset management in place
  • Potential for stable income via triple net leases

Simplicity

  • Turnkey real estate investment without having to self-manage properties
  • Pre-determined exit strategy when DST offering matures

Built-in Debt: A Helpful Shortcut

Imagine you sell a property for 300,000 but owe 100,000 still. After paying that off you'd have 200,000 left.

For a 1031 exchange, you'd need to reinvest the full 300,000. What can you do? Here are some options:

  • Add $100,000 of your own cash
  • Borrow $100,000 from a bank
  • Invest in a DST with debt included

DST Property Management

One of the advantages of DST investments is the passive nature of the income it generates for investors.

The day-to-day management of the properties, including leasing, maintenance, and tenant relations, is handled by the DST sponsor or a designated property manager.

This allows investors to benefit from real estate ownership without the burdens of direct management.

What are some due diligence steps before investing in a DST?

Work with your financial advisor to evaluate adding a DST, reviewing if it aligns with asset allocation targets, liquidity needs, time horizon, income generation, and diversification goals.

Compare to direct real estate ownership. The suitability of a DST depends on your personal financial situation.

DSTs involve 1031 exchange timelines like 45-day identification periods and 180-day purchase deadlines that govern the tax-deferred transaction.

So review details with an advisor to see if a DST makes sense for your portfolio and investment objectives.

Research the Portfolio Properties

  • Location, quality, tenant history
  • Third party valuation reports
  • Debt terms and structure

Vet the Sponsors/Management

  • Track record and past performance
  • Assets under management
  • Fees structure
  • Alignment of interest

How might a DST fit into my overall investment portfolio?

Work with your financial advisor to see if adding a DST investment aligns with your risk-return objectives and provides portfolio diversification.

Things to review:

  • Target asset allocation percentages for real estate
  • Liquidity needs and investment time horizon
  • Suitability relative to other income generating alternatives
  • How it compares to direct real estate ownership

The right DST, if any, depends on your personal financial situation.

Technical Aspects and Requirements

DSTs aim to replicate the debt-to-equity ratio from the sold property to properly defer taxes.

Investors want to minimize "boot" - the non tax-deferred portion of the exchange proceeds - by purchasing a replacement property equal or greater in value to the relinquished property.

DSTs typically require accredited investor status meeting SEC net worth and income rules, providing access to higher-minimum investments suited for sophisticated investors.

Investing in multiple DST properties across locations and asset classes allows for diversification to spread risk.

DST ownership is passive with no control over day-to-day management. This appeals to investors wanting real estate exposure without direct operational responsibilities.

Upon an investor's death, a DST's tax basis steps up to fair market value, potentially providing substantial tax savings for heirs.

However, 1031 exchange tax regulations could change in the future, so investors should monitor any legislative or regulatory developments.

Debt-to-Equity Ratio

  • Debt on replacement property should replicate debt-to-equity ratio of sold property to properly defer taxes

Boot

  • Non tax-deferred portion of the exchange proceeds
  • Minimize boot by purchasing replacement property equal or greater value than sold property

Accredited Investor

  • DSTs typically require investor to be accredited based on SEC net worth/income requirements
  • Provides access to investments with higher minimums meant for sophisticated investors

Diversification

  • Invest in multiple DST properties across geographic locations and asset classes to spread risk

Passive Ownership

  • DST investors have no control over day-to-day property management or operations
  • Appeals to investors wanting exposure without direct management responsibilities

Estate Planning and Legislative Impacts

Estate Planning Benefits

  • Upon investor's death, tax basis of DST investment steps up to fair market value
  • Can provide substantial tax savings for heirs/beneficiaries

Tax Law Changes

  • Tax regulations related to 1031 exchanges could change in future
  • Investors should monitor legislative/regulatory developments

Other Things to Consider About DSTs and 1031 Exchanges

The IRS mandates strict timelines for properly executing 1031 exchanges with DSTs.

Investors have limited days to identify and purchase replacement properties while professionals like Qualified Intermediaries, real estate agents, and CPAs collaborate to meet compliance requirements.

Their guidance facilitates the intricacies of these tax-deferred transactions. Key deadlines must be observed to achieve the tax benefits.

Timelines and Deadlines

Exchanges must adhere to strict IRS timelines. Investors have 45 days after selling a property to identify up to 3 replacement properties of any value, or more if their total value doesn’t exceed 200% of the sale price.

The actual property purchase must be completed within 180 days of the sale. Qualified Intermediaries hold funds and facilitate compliant transactions.

Identification Period

  • 45 days from sale of relinquished property to identify potential replacement properties
  • Can identify up to 3 potential replacement properties without regard to fair market value
  • Or identify any number of potential replacement properties as long as combined fair market value does not exceed 200% of the value of the relinquished property

Purchase Deadline

  • 180 days from sale of relinquished property to complete purchase of replacement property
  • If more than 3 potential replacement properties identified, must acquire at least 95% of the value of all identified properties

The Role of Key Players

Real estate agents identify suitable replacement properties matching investors’ objectives. CPAs provide tax guidance to maximize deferral benefits.

These professionals work together to ensure investors successfully navigate the complex 1031 exchange process and requirements when using DSTs.

Qualified Intermediary (QI)

  • Holds proceeds from sale of relinquished property in escrow account
  • Structures the transaction to facilitate the exchange by preparing exchange documents
  • Ensures investor does not take constructive receipt of funds, which would disqualify the exchange

One of Our Tim M. Clarke Team Agents

  • Helps identify high-quality replacement properties that match or exceed value of sold property
  • Tailors property options to investor's goals like cash flow, appreciation potential, location
  • Navigates intricacies of exchange process and identification/timing requirements

CPA

  • Advises on tax implications at each stage, including depreciation recapture, capital gains liability
  • Ensures full compliance with 1031 rules and maximum tax deferral benefit
  • Collaborates with agent to provide cohesive guidance on calculating basis, boot, debt relief

Final Thoughts From Tim

As a real estate professional with over 17 years of experience here in the Triangle, I've helped many investors, buyers and sellers navigate the intricacies of 1031 exchanges and Delaware Statutory Trusts.

My top recommendation is to work closely with your CPA and real estate agent from the start if you're considering either as part of your tax and investment strategy.

These transactions can get complex, with strict identification deadlines and reinvestment rules. Having trusted professionals guide you through the process is invaluable.

As your real estate agent, I'll help you identify high-quality DST or 1031 replacement properties tailored to your goals.

Your CPA will advise on the tax implications at each stage, ensuring full compliance and maximum tax deferral.

Communication is key - your CPA and I will collaborate to provide cohesive guidance. We’ll “speak the same language” so there’s no confusion on matters like calculating basis, depreciation recapture, boot, debt relief and more.

Our shared expertise provides a smoother process so you can focus on long-term wealth building rather than get lost in tax minutiae.

With the right team in place, DST 1031 exchanges can unlock substantial tax incentives and enhanced investment opportunities.

Trusted relationships and frequent check-ins lead to successful transactions where all parties have peace of mind.

As a Triangle resident for over 30 years, I take pride in leveraging my regional knowledge and network to deliver optimal outcomes.

Let’s connect to explore how DST 1031 strategies can help you meet your real estate investment and tax planning goals.

Frequently Asked Questions About DST's

What is a Delaware Statutory Trust (DST)?

A DST is a legal entity created under Delaware law that can hold title to investment properties. It allows multiple investors to hold fractional ownership in the trust, which in turn owns real estate assets.

How does a DST work for a 1031 exchange?

In a 1031 exchange, a DST allows investors to defer capital gains taxes by reinvesting the proceeds from the sale of a property into a fractional interest of a larger, institutional-grade property owned by the DST.

What are Replacement Property Interests (RPIs)?

RPIs are equity ownership interests in large properties that multiple 1031 exchange investors hold through DSTs and Tenant-In-Common (TIC) structures. They allow investors to co-invest in larger properties than they could individually.

What is the role of the "sponsor" in a DST?

The sponsor is a real estate company responsible for operating the properties offered through the DST. They handle the management, leasing, upkeep, taxes, insurance, and investor reporting.

Can a DST qualify for a 1031 exchange?

Yes, a DST is considered like-kind property for the purposes of a 1031 exchange, allowing investors to defer capital gains taxes on the sale of an investment property by reinvesting the proceeds into a DST.

What is the time frame for completing a 1031 exchange with a DST?

Investors have 45 days from the sale of the relinquished property to identify potential replacement properties and 180 days to complete the purchase of the replacement property, which can include a DST.

What is an accredited investor in the context of a DST?

An accredited investor is someone with an annual income of 200,000 (300,000 for joint income) for the last two years or a net worth exceeding $1 million, excluding the value of their primary residence.

How long does one typically hold a DST investment?

DST investments are often held for 4-10 years. They are considered long-term due to their illiquid nature, so investors should be prepared for this time commitment.

What happens when a DST is sold?

When a DST is sold, investors receive their share of the sale proceeds proportional to their initial investment and any appreciation. They can then choose to reinvest in another DST, pay capital gains taxes, or do a combination of both.

What happens to my DST investment if I die?

If an investor passes away before the DST is liquidated, the investment interest will pass to their heirs. The tax basis of the investment is stepped up to the fair market value at the time of the investor's death, potentially providing tax benefits to the heirs.

Tim M. Clarke

About the author

17 years as a Realtor in the Research Triangle, Tim seeks to transform the Raleigh-Durham real estate scene through a progressive, people-centered approach prioritizing trust & transparency.

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