The Delaware Statutory Trust (DST) was established in July of 2004 via a revenue ruling (200486) of the IRS. The DST essentially allows real estate investors to utilize a 1031 Exchange to go from 100% active ownership in investment property, to passive, fractional ownership in institutional grade property. Within a 1031 exchange, DST property can help investors defer depreciation recapture, capital gains, and net investment income taxes. This article explores the fundamentals of a DST, its role in a 1031 exchange, and the potential benefits and risks associated with this strategy.

What is a Delaware Statutory Trust (DST)?

A Delaware Statutory Trust is a legal entity created under Delaware law that allows multiple investors to co-own a fractional interest in real estate. The trust holds the title to the property, and investors become beneficiaries of the trust. Each investor shares in the income, tax benefits, and potential appreciation of the property on a pro rata basis without taking on direct management responsibilities. DSTs are often used to hold large commercial properties, such as multifamily apartments, self storage, senior living, and industrial, amongst other property types. The trust is managed by a trustee or sponsor who handles all operational aspects, including leasing, maintenance, and financing.

Understanding the 1031 Exchange

A 1031 exchange, named after Section 1031 of the Internal Revenue Code (IRC), allows investors to defer paying capital gains taxes on the sale of investment property by reinvesting the proceeds into another qualifying property. To qualify for this tax deferral, the exchange must meet specific criteria, including:

Like-Kind Property: The replacement property must be of the same nature or character as the relinquished property.

Timelines: Investors have 45 days to identify replacement properties and 180 days to complete the transaction from the date of the sale.

Equal or Greater Value: The replacement property must be of equal or greater value than the sold property to defer all capital gains taxes.

How DSTs Fit into a 1031 Exchange

Investing in a DST can be an attractive option for 1031 exchange investors. Since DSTs hold real property, they qualify as like-kind assets under 1031 exchange rules. Investors can use their proceeds from a property sale to acquire an interest in a DST, which satisfies the requirements for a tax-deferred exchange.

DSTs offer several advantages for 1031 exchange participants:

1. Passive Investment: DSTs relieve investors of the burden of property management, making them ideal for those seeking a hands-off approach.
2. Diversification: Investors can acquire fractional interests in multiple DSTs, spreading their risk across various properties and asset classes. Diversification may also be achieved by geography, exit strategy, use of leverage, and sponsor.
3. Access to High-Value Assets: Through DSTs, investors can participate in the ownership of institutional-grade properties that might otherwise be out of reach.
4. Simplified Identification Process: Since DSTs are pre-packaged investments, they can streamline the 45-day identification requirement in a 1031 exchange. They may also serve as an excellent back-up option in a 1031 Exchange.
5. Estate planning: DST interests are easily divisible amongst beneficiaries. Additionally, in some cases, the DST can help the family save on estate taxes.
6. Increase in Return on Equity: Oftentimes exchangers will experience a meaningful increase in income post exchange.

Potential Risks and Considerations

While DSTs offer many benefits, investors should also be aware of potential risks and limitations:

1. Illiquidity: DST investments are not easily sold or transferred, making them relatively illiquid. Investors should plan on a hold period of 5-8 years, and in some cases, even longer. Although there are some structures available for earlier liquidity, for a traditional DST, the typical period is 5-8 years. There is no secondary market for DST interests.
2. Lack of Control: Investors have no direct control over property management decisions, which are handled by the trustee or sponsor. For some investors, this is a positive attribute of the DST as they no longer wish to handle the operation of their rental portfolio. However, it is important that strong due diligence has been performed on both the sponsor and the property itself.
3. Market and Operational Risks: As with any real estate investment, DSTs are subject to market fluctuations and operational risks, such as vacancies or declining property values. DST property is not immune to regulatory risk, interest rate risk, property specific risk, or market risk. Unexpected rises in expenses, such as property taxes and insurance, may result in a decline in distributions.
4. Compliance Requirements: Investors must adhere to strict 1031 exchange rules and DST guidelines to maintain their tax-deferral benefits. The same identification rules apply to folks utilizing DST property for a 1031 exchange. It is important to work with an advisor who is familiar with these rules and how they apply to your specific exchange. 

Steps to Invest in a DST through a 1031 Exchange

Investors interested in using a DST for a 1031 exchange should follow these steps:

1. Consult with Professionals: When planning for a successful 1031 Exchange, it is highly advantageous to be proactive. Begin the conversation with your advisor(s) before listing the property. Evaluate your options. The strategy that is selected should be the one that is most aligned with your goals and objectives. The strategy should be suitable given your specific financial situation. In some cases, depending on your goals and objectives, you may be better off simply selling the property and paying the taxes.
2. Identify Suitable DSTs: Should DST replacement property be the most effective strategy for your exchange, research available DST offerings, focusing on property types, locations, and investment strategies that align with your goals and objectives.
3. Perform Due Diligence: Work with your advisor. Your advisor and their team should have a robust due diligence team who evaluates the trust’s sponsor, financial projections, property condition, and market trends. One of the biggest mistakes we see investors make is solely focusing on the first-year projected cash flow of the DST property.
4. Complete the Exchange: Execute the 1031 exchange by acquiring a fractional interest in the selected DST within the required timelines. Oftentimes, this can mean working with your advisor to reserve equity in a specific DST, ensuring that the correct property identification protocol has been followed, submitting the identification, and preparing the proper closing documentation.

Conclusion

A Delaware Statutory Trust can be an excellent option for real estate investors seeking to complete a 1031 exchange. By offering passive investment opportunities, diversification, and access to institutional grade properties, DSTs provide a flexible solution for preserving capital gains and building wealth. However, investors should carefully assess the risks and consult with professionals to ensure a successful and compliant exchange.

This communication is general in nature and provided for educational and informational purposes only. It should not be considered or relied upon as legal, tax or investment advice or an investment recommendation, or as a substitute for legal or tax counsel. Any investment products or services named herein are for illustrative purposes only and should not be considered an offer to buy or sell, or an investment recommendation for any specific security, strategy or investment product or service. Always consult a qualified professional or your own independent financial professional for personalized advice or investment recommendations tailored to your specific goals, individual situation, and risk tolerance. DST 1031 Exchanges are complex investment strategies subject to specific IRS regulations under Section 1031 of the Internal Revenue Code.

McKeon Financial was established in 2004, specializing in a wide range of alternative investments. We are focused on retirement planning, wealth accumulation, insurance protection, and estate and legacy planning. When consulting, educating, and initiating tax savings strategies, we work closely with our clients’ tax and legal professionals.

McKeon Financial offers securities and advisory services through Independent Financial Group, LLC (IFG), a registered broker-dealer and investment advisor. Member FINRA/SIPC. McKeon Financial and IFG are unaffiliated entities. If you have questions regarding the material presented, please don’t hesitate to contact us: 360-652-4244 or info@mckeonfinancial.com.