Defer All Tax when Moving to Passive Real Estate Investing: How to 1031 Exchange into a DST (Delaware Statutory Trust)
For accredited investors looking to move from active to passive investing, there are opportunities to 1031 exchange real estate investments into passive DST (Delaware Statutory Trust) investments without paying tax. DSTs are becoming a more common route to passive investing as the market matures. Here we will clearly define a DST and give a few of the advantages and disadvantages of moving into this type of passive real estate investing using the 1031 exchange.
What is a DST?
A Delaware Statutory Trust (DST) is a passive investment opportunity that allows investors to own fractional shares of properties held by the trust. Within the DST, a trustee (also known as the sponsor) holds title to assets that benefit the trust interest owners.
Accredited investors are beneficiaries of the Delaware Statutory Trust. The IRS treats DST interest as direct property ownership, thus qualifying it for a 1031 exchange. DSTs were formalized as qualifying replacements for 1031 exchanges in 2004 with the adoption of Revenue Procedure 2004-86.
Examples of DST investments are portfolios such as commercial buildings (from retail to storage), multifamily complexes, and various other types of industrial, commercial, and residential real estate.
What is a 1031 Exchange?
A 1031 exchange allows real estate investors to defer their capital gain taxes when they sell. To qualify, they must transition into another investment property. The IRS tax code has several other steps that an investor must take to use the 1031 exchange, as explained in the series The Six Basic Requirements of a 1031 Exchange.
What are the Advantages of a DST?
There are many advantages to investing in DSTs. First, for the accredited investor, they are able to move into a completely passive mode and no longer have to deal directly with bank finances and property management. No more trash, toilets, and tenants to manage.
Second, DSTs offer investors access to higher-quality assets that are typically only available to large institutions. And this still provides investors with all of the benefits of regular real estate ownership including cash flow, appreciation, and tax write-offs such as depreciation.
Another benefit is that debt within DSTs is non-recourse. Most DSTs already carry institutional-grade debt. The investor assumes their pro-rata share of the debt but does not have to qualify for it. This debt is non-recourse to the investor, which means that the DST investor is not personally liable. The non-recourse debt inside the DST can free up leverage capability for the investor allowing them to be more aggressive in their borrowing outside the DST. It is also important to note that investors do reserve all rights of real estate ownership, including the ability to 1031 exchange back into fixed real estate when the DST matures, typically in 3-6 years. Current rates of return are generally 4-7.5% on the cash invested. All of these advantages make DSTs popular with investors wanting passive investments.
What are the Disadvantages of a DST?
A disadvantage with DST investments are lack of control, which can be deemed a hurdle to those used to handling all decision-making. Property upgrade, for example, is left up to the sponsor, who is responsible for making decisions on the investors’ behalf. Another downside to DSTs is that the amount of debt is not controlled by the investor. Even non-recourse debt can leave the asset at risk. However, there are restrictions on new borrowing in DSTs, as DSTs cannot raise new capital. This can be either a protection or a disadvantage for the investor. The sponsor cannot irresponsibly take on more debt. But, if the property needs updating, years of profits may have to be used and could reduce property cash flow for the investors. Both advantages and disadvantages need consideration before investing in DSTs.
A Final Word on DSTs
To recap, DSTs may provide a solution for accredited investors looking to invest their time on something other than managing their properties. The move to DSTs could be spurred by a desire to travel or spend time with family, or to off-load the increasing work on an aging property. There is no shame in wanting to step into a more passive role.
There are advantages and disadvantages to DST investments. Return on cash invested is typically superior to leveraged investments that are high in appreciation and low in cash flow. Alternatively, there is a loss of control in return for the freedom from hands-on management. Above all, investors should research the operators, properties, and legal structure of DSTs. Seek advice from a professional financial advisor. They can help assess if a DST investment is an appropriate investment for individual financial circumstances and goals.