Delaware Statutory Trusts (DSTs) offer a smart avenue for real estate investors navigating the complexities of a 1031 Exchange. When the IRS issued Revenue Ruling 2004-86(1), it allowed a properly structured DST to qualify as a like-kind 1031 exchange replacement property, which allows investors to defer capital gains taxes accumulated since the investor originally purchased the property. In some cases, this could total up to 40% of the sales price.
So obviously, using DSTs as a tax-advantaged investment strategy is one of the most popular uses for the Delaware Statutory Trust. However, there are other advantages as well.
Diversification
One of these potential benefits of investing in a DST is diversification*. Just how do Delaware Statutory Trusts help investors achieve potential diversification? Let’s say an investor were to purchase a single property with their entire 1031 exchange proceeds. This might mean they are using a substantial amount of their total net worth in the exchange, and potentially over-concentrating their net worth into a single asset. For example, an investor with a $5 million dollar net worth, excluding their primary residence, purchasing via a 1031 exchange a property worth $3.5 million. This would be considered a classic case of an investor overconcentrating on a single property and taking on a much higher level of risk to their net worth than they are aware of.
On the other hand, one of the benefits of Delaware Statutory Trusts is that they are designed around the fundamental investment strategy of “not putting all your eggs into one basket.” Delaware Statutory Trust properties enable investors to diversify* their equity proceeds across multiple properties, thus creating the potential for a more diversified portfolio. This diversification extends across different asset classes, such as medical facilities, multifamily units, self-storage, manufactured housing, industrial properties, and long-term net lease buildings. Moreover, DST investors potentially benefit from diverse tenants, including well-known companies like FedEx, UPS, Amazon, Fresenius, DaVita, and more. Geographic diversification is also possible, as investors can spread their holdings across various states, cities, and sub-markets, potentially mitigating the risk associated with a single location. It is important to remember that diversification never guarantees profits or protection from losses.
The DST entity can be used to hold title to most types of real estate; however, a typical DST 1031 property is a triple net (NNN) leased industrial or essential business property or a multifamily apartment community. A NNN leased property is a property whereby the tenant (and not the landlord) is typically responsible for property maintenance costs, insurance premiums, and property taxes.
Other types of DST 1031 properties that have been available to investors have included shopping centers, government-leased buildings, self-storage facilities, senior living communities, warehouses, distribution facilities, medical office buildings, fast food buildings, pharmacies, and grocery stores.
Typically, at any given time, Kay Properties has 20 to 40 DST 1031 properties available to our qualified, accredited clients, with a typical minimum investment of $100,000.
However, in order for a property to qualify for a 1031 Exchange, the IRS issued seven limitations on the trustee of any DST property. Colloquially known as “the seven deadly sins”, these restrictions include:
- Once the offering is closed, there can be no future contributions of capital to the DST by either current or new co-investors or beneficiaries.
- The Trustee of the DST cannot renegotiate the terms of the existing loans, nor can it borrow any new funds from any other lender or party.
- The Trustee cannot reinvest the proceeds from the sale of its real estate.
- The Trustee is limited to making capital expenditures with respect to property to those for (a) normal repair and maintenance, (b) minor non-structural capital improvement, and (c) those required by law.
- Any liquid cash held in the DST between distribution dates can only be invested in short-term debt obligations.
- All cash, other than necessary reserves, must be distributed to the co-investors or beneficiaries on a current basis.
- The Trustee cannot enter into new leases or renegotiate the current leases.
By enabling fractional ownership in diverse properties, DSTs allow you to diversify your investments without the burdens of direct property management.
This can be especially beneficial for those seeking to defer capital gains taxes while maintaining a diversified portfolio. Dwight Kay, Founder and CEO of Kay Properties and Investments, dives into the strategic advantages of DSTs and learns how they can play a pivotal role in your investment strategy.
Overview of Delaware Statutory Trusts
Delaware Statutory Trusts (DSTs) offer real estate investors a streamlined way to diversify investments and defer capital gains taxes in a 1031 Exchange. Their unique structure allows investors to pool resources while maintaining a distinct legal framework, making them attractive for those seeking efficiency and protection.
Approved for 1031 Exchanges by IRS Revenue Ruling 2004-86, a DST can qualify as “real property” under IRC §1031, allowing investors to use it as a replacement property in a 1031 exchange, provided the Trust holds the business.
- Key requirements from the ruling:
- The DST must hold real estate (not operating businesses).
- Investors (beneficiaries) cannot actively manage the trust (passive ownership only).
- The trustee has exclusive control over decisions (e.g., leases, refinancing).
Created under Delaware law, DSTs enable multiple investors to own fractional interests in a single property, with trustees managing operations. This hands-off approach frees investors from day-to-day decision-making, while a trust agreement ensures transparency and legal protection. Professional asset managers oversee property operations, and non-recourse financing reduces investor liability.
A key advantage of DSTs is the potential for passive income. Investors receive returns from rental income based on their ownership share without needing to manage properties directly. This makes DSTs appealing to seasoned investors and newcomers seeking a passive way to grow their portfolio.
DSTs offer opportunities for property diversification, helping investors manage risk by spreading investments across different markets.
For those navigating the strict timelines of a 1031 Exchange, DSTs provide the flexibility and speed needed to meet IRS regulations. The ability to quickly acquire properties through a DST structure makes it an efficient tool for investors seeking protection and growth in real estate.
The 1031 Exchange Explained
Navigating real estate investment can be challenging, especially when maximizing tax benefits. The 1031 Exchange is a powerful strategy that allows investors to defer capital gains taxes when selling a property. Understanding its core requirements and the tax benefits of a 1031 Exchange can help investors make informed decisions and enhance financial outcomes.
To qualify for a 1031 Exchange, specific criteria must be met. The properties involved must be held for investment or used in a trade or business, ensuring the exchange isn’t merely a swap of personal assets. Additionally, both the relinquished and replacement properties must be located within the United States to comply with IRS regulations.
Investors must also identify potential replacement properties within 45 days of selling the original property, with a deadline of 180 days for acquisition. The new property must be of like-kind, broadly interpreted by the IRS to include various real estate types, though its value should be equal to or greater than that of the sold property.
The primary advantage of a 1031 Exchange lies in its ability to defer capital gains taxes. By reinvesting sale proceeds into a similar property, investors can postpone tax payments, allowing for greater purchasing power and portfolio growth. Additionally, this strategy enables a transition from underperforming assets to higher-yield properties without immediate tax burdens.
If held until death, the taxes deferred through a 1031 Exchange can potentially be eliminated, as beneficiaries receive a “step-up” in basis, reducing capital gains tax upon sale. This feature enhances legacy planning, providing a tax-efficient way to pass on real estate wealth to heirs. For savvy investors, leveraging the tax benefits of a 1031 Exchange can offer both immediate tax relief and long-term financial advantages.
Integrating DSTs in a 1031 Exchange
Delaware Statutory Trusts (DSTs) can be an appealing option in a 1031 Exchange, enabling you to align your investment decisions with your financial goals. For a DST to qualify as a replacement property, it must adhere to specific IRS criteria, including being recognized for fractional ownership of real estate assets. This allows you to exchange your relinquished property for an interest in a DST without triggering immediate capital gains tax.
DSTs comply with IRS Revenue Ruling 2004-86, which confirms their eligibility by stipulating that a DST must have legal ownership and manage the real estate while individual investors maintain a passive role. This structure aligns with the like-kind requirement of a 1031 Exchange, legitimizing the transaction as a swap of investment properties.
Engaging in a 1031 Exchange with a DST involves critical steps. First, you must identify potential DST investments within the 45-day window after selling your initial property, assessing various offerings that match your investment goals and risk tolerance.
Next, it’s essential to complete your purchase within the 180-day exchange period, which includes the initial 45 days for identification. Timely action is vital to avoid disqualification from the exchange. Throughout this process, a qualified intermediary will oversee the exchange, hold the sale proceeds, and guide you through compliance with IRS regulations to maintain tax-deferred status.
Notes Kay, “Incorporating DSTs into a 1031 Exchange presents a strategic opportunity to diversify your real estate portfolio, defer taxes, and reduce management burdens.”
Each step is crucial to maximizing the benefits DSTs offer within this framework.
Considerations and Challenges
While Delaware Statutory Trusts (DSTs) provide benefits in a 1031 Exchange, it’s essential to understand the associated risks and market dynamics for a balanced investment strategy.
A primary concern is the lack of control over property management, as professional managers make all decisions, which may not align with your investment goals. Illiquidity is another risk; capital is typically locked in until the property is sold, which can take years and may be problematic if your financial situation changes unexpectedly.
Additionally, rising interest rates can squeeze cash flow and diminish property values. Broader economic trends significantly impact DST performance. Inflation is crucial as well. While real estate often hedges against inflation, rising costs for maintenance, insurance, and property taxes can erode net profits.
“Examine current economic indicators and real estate trends before committing to a DST, ensuring alignment with your risk tolerance and investment goals. Also, investors are encouraged to read the DSTs Private Placement Memorandum (PPM) for a full discussion of the risk factors of investing,” says Kay.
Understanding Delaware Statutory Trusts (DSTs) is crucial when considering a 1031 Exchange. This innovative approach allows investors to diversify and defer taxes, enhancing real estate portfolios without management hassles. DSTs ensure compliance with IRS rules while granting investors tax advantages and diversification potential.
The synergy between DSTs and 1031 Exchanges creates opportunities for smart real estate investing. By opting for DSTs, investors gain access to quality properties and professional management, making it a compelling option for many investors.
About Kay Properties and www.kpi1031.com:
Kay Properties helps investors choose 1031 exchange investments that help them focus on what they truly love in life, whether that be their children, grandkids, travel, hobbies, or other endeavors (NO MORE 3 T’s – Tenants, Toilets and Trash!). We have helped 1031 exchange investors for nearly two decades exchange into over 9,100 – 1031 exchange investments. Please visit www.kpi1031.com for access to our team’s experience, educational library and our full 1031 exchange investment menu.
This material is not tax or legal advice. Please consult your CPA/attorney for guidance. Past performance does not guarantee or indicate the likelihood of future results. Diversification does not guarantee returns and does not protect against loss. Potential cash flow, potential returns and potential appreciation are not guaranteed. There is a risk of loss of the entire investment principal. Please read the Private Placement Memorandum (PPM) for the offerings business plan and risk factors before investing. Securities offered through FNEX Capital LLC member FINRA, SIPC.
DISCLAIMER: No part of this article was written by The Signal editorial staff.
