Understanding DSTs: Leveraging Them for 1031 Exchanges
By Paul Chastain on June 17, 2023
Understanding DSTs: Leveraging Them for 1031 Exchanges
DST stands for Delaware Statutory Trust, a legal entity established according to Delaware law. It is important to note that the property and investors associated with a DST are not required to be situated in Delaware. In a DST, every investor possesses a stake in the Trust, which ultimately holds ownership of the property.
These investors are referred to as "beneficiaries" of the Trust. Consequently, the ownership rights held by investors in a DST are known as "beneficiary interests." Notably, the Internal Revenue Service (IRS) treats DST beneficiary interests as equivalent to direct property ownership, thereby making them eligible for a 1031 exchange.
1031 Exchange Explained
A 1031 exchange is a tax deferral strategy widely employed by real estate investors to optimize their investments. It entails utilizing the proceeds obtained from the sale of an investment property to acquire another property that is considered "like-kind" in the eyes of the tax code.
By engaging in a 1031 exchange, investors can defer the payment of capital gains taxes that would typically arise from the sale of their assets. This allows them to retain a larger portion of their proceeds from a sale, facilitating the creation of a more diverse investment portfolio.
In the context of Delaware Statutory Trusts (DSTs), 1031 exchanges present a unique opportunity to expand one's investment horizon and potentially access high-value properties. DSTs offer a vehicle for investors with limited funds to participate in the ownership of premium commercial properties, such as retail spaces, apartment complexes, and industrial facilities. By pooling their resources together in a DST, individual investors gain the ability to collectively acquire these sought-after properties.
Once an investor becomes a beneficiary in a DST and holds passive ownership in a high-dollar property, the benefits of a 1031 exchange continue to play a significant role. By leveraging subsequent 1031 exchanges, investors can defer their tax liabilities and effectively roll their investment gains into additional high-end assets. This strategy enables them to perpetuate the growth of their investment portfolio while deferring the payment of capital gains taxes until a future date.
In order for a Delaware Statutory Trust (DST) to qualify under Section 1031 for a like-kind exchange, there are key guidelines set forth by the IRS. These guidelines include:
1. Unlimited Beneficiaries: While the number of beneficiaries in a DST is generally capped at 499 in practice, there is no strict limit imposed by the IRS.
2. Trustee Decision-Making: The Trustee of the DST is responsible for making material decisions, rather than the individual investors. This structure ensures a centralized decision-making process.
3. Passive Real Estate Holding: The DST operates as a passive holder of real estate. Trustees have limited powers, and beneficiaries (investors) do not have authority over property operations.
The DST structure offers several structural advantages, including:
1. Limited Liability: Similar to a limited liability company (LLC) or corporation, the DST structure protects investors from personal liabilities beyond their investment amount.
2. Bankruptcy Protection: The DST structure safeguards individual investors from creditors pursuing the DST's debts. It also prevents investors from placing liens on the DST's property, providing additional protection to mortgage lenders and other beneficiaries.
3. Centralized Control: Major decisions within the DST are made by a single Trustee, eliminating concerns or disagreements among investors.
4. Single Borrower: The DST acts as the sole borrower and owns 100% of the property. This simplifies the process of obtaining a mortgage, as there is no need to coordinate multiple borrowers.
5. Permissible Number of Investors: DSTs can accommodate a large number of beneficiaries, with no strict limit imposed by the IRS (though it is typically capped at 499). This allows for the purchase of institutional quality properties, spread across a larger number of investors, and provides the advantage of lower investment minimums.
6. Pre-Packaged Investments: DSTs often offer pre-acquired properties with mortgages already in place. This simplifies the investment process for investors using 1031 exchange funds, as they can easily purchase fractional DST investments without the complexities of property acquisition and mortgage arrangements.
These guidelines and structural advantages make DSTs an attractive option for investors seeking the benefits of a like-kind exchange while enjoying limited liability, centralized control, and access to institutional-grade properties.
While the Delaware Statutory Trust (DST) structure offers numerous advantages, it is important to note the limitations that must be considered for qualification in a 1031 exchange. These prohibitions include:
1. Capital Contributions: Once the DST is closed, investors are not permitted to make additional capital contributions to the trust.
2. Loan Terms: The Trustee of the DST cannot renegotiate the terms of existing loans or secure new funds through borrowing.
3. Proceeds from Property Sales: If a property owned by the DST is sold, the Trustee is obligated to return the proceeds to the investors rather than reinvesting them in another property.
4. Capital Expenditures: The DST is restricted in terms of capital expenditures it can make on its properties. These expenditures are typically limited to normal repair and maintenance, non-structural improvements, and those mandated by law.
5. Investment of Cash: Cash held by the DST between distributions to investors can only be invested in short-term debt securities such as US Treasury bills.
6. Cash Distribution: With the exception of reserves, all cash must be regularly distributed to the beneficiaries (investors).
7. Leases: The Trustee is prohibited from entering into new leases or renegotiating existing leases.
Despite these limitations, fractional property investments through DSTs remain an appealing option for investors engaged in 1031 exchanges. This structure enables investors to participate in larger, higher-quality assets that might be otherwise out of their reach. Additionally, the pre-packaged nature of DSTs simplifies the investment process and helps investors meet the strict timelines required for exchanges. It is worth noting that DSTs are generally best suited for investors seeking longer-term, passive investment opportunities.
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Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.
1031 Risk Disclosure:
There’s no guarantee any strategy will be successful or achieve investment objectives;
All real estate investments have the potential to lose value during the life of the investments;
The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;
All financed real estate investments have potential for foreclosure;
These 1031 exchanges are offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.
If a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;
Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits
Securities offered through Emerson Equity LLC, member FINRA / SIPC. This is not an offer to buy or sell securities. Securities investing carries an inherent risk of loss of some or all of the principal invested. We are not tax professionals. You should always discuss your investments with a tax professional prior to investing. Securities are sold only in those states where Emerson Equity LLC is registered. Perch Wealth LLC and Emerson Equity LLC are not affiliated. COMPANY and Emerson Equity LLC do not provide legal or tax advice. Securities offered through Emerson Equity LLC Member FINRA / SIPC and MSRB registered. Emerson Equity LLC is unaffiliated with any entity herein.
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Perch Financial LLC and Emerson Equity LLC do not provide legal or tax advice. Securities offered through Emerson Equity LLC Member FINRA/SIPC and MSRB registered. Emerson Equity LLC is unaffiliated with any entity herein. 1031 Risk Disclosure:
There is no guarantee that any strategy will be successful or achieve investment objectives;
Potential for property value loss – All real estate investments have the potential to lose value during the life of the investments;
Change of tax status – The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;
Potential for foreclosure – All financed real estate investments have potential for foreclosure; ·Illiquidity – Because 1031 exchanges are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments;
Reduction or Elimination of Monthly Cash Flow Distributions – Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;
Impact of fees/expenses – Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits
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