Are DSTs a Good Investment? An Investor’s Guide by FNRP

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Key Takeaways

  • A Delaware Statutory Trust is a specialized type of legal structure that is formed for the purpose of conducting business. As it relates to real property, it is a useful structure to allow individual real estate investors to purchase fractional shares of an institutional grade investment property.
  • The major benefit of a DST investment is that it qualifies as a replacement property in a 1031 Exchange, which means that investors can allocate money to DST investments in an effort to defer income taxes on the profitable sale of an investment property.
  • Other major benefits of a DST investment include: passive income, depreciation, ability to diversify an investment portfolio, relatively low minimum investment amounts, and the ability to pass them on to heirs at a stepped up cost basis.
  • Potential downsides of a DST investment are that they require lengthy holding periods, are illiquid, and the sponsors charge fees that may chip into overall returns.
  • To determine whether a DST is a good real estate investment, investors should consider their own unique circumstances and preferences. If there are any questions about suitability, it is always a good idea to work with an investment advisor.

 

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Selling a commercial investment property for a profit is a good new/bad news scenario. The good news is that a profit was made, which is always welcome. The bad news is that the profit may be subject to capital gains tax, which can vary based on the amount of the profit. Fortunately, there are strategies that real estate investors can use to defer taxes on the gain.

In this article, we are going to describe one such real estate strategy, which is to invest the sale proceeds in a specialized type of investment entity known as a Delaware Statutory Trust (DST). We will describe what a DST is, how it works, why it can be a good investment, and the pros and cons of allocating funds to one. By the end, readers will have the information needed to determine if a DST is a good real estate investment option for their own unique circumstances.

At First National Realty Partners, we specialize in the acquisition and management of grocery store anchored retail centers. As part of this effort, we work with investors on transactions that involve a DST. If you are an Accredited Investor and would like to learn more about our current investment opportunities, click here.

The Setup

The first thing to know about a DST investment is that they can be made in a number of scenarios, but there is one where it tends to be most useful.

In a very simple example, assume that an investor purchased a commercial property for $500,000 and sold it ten years later for $1,000,000. The difference between the purchase price and the sales price, $500,000, is considered to be a “gain” and it is taxable. The exact amount of tax due is dependent upon the length of time the property was held and the investor’s income tax bracket, but it can be deferred if the sales proceeds are reinvested into a “replacement property” that is considered to be “like kind” to the property that was sold (the “relinquished property”). This type of transaction is known as a “1031 Exchange.”

So, the key point is that real estate investors like 1031 Exchanges because they can be used to defer capital gains tax, but to complete one correctly, a “replacement property” must be found within a certain period of time. This is where a DST comes into the picture.

What is a Delaware Statutory Trust?

A Delaware Statutory Trust (which may or may not be located in Delaware) is a specialized type of legal entity that is formed for the purpose of conducting business. As it relates to commercial real estate investment, the DST structure is helpful because it allows individual investors to purchase a fractional share of commercial real estate assets that they likely could not afford on their own.

This structure can potentially provide a number of financial benefits to investors.

Benefits of Investing in a Delaware Statutory Trust

Perhaps the most important, and commonly cited, benefit of a Delaware Statutory Trust investment is that IRS Revenue Ruling 2004-86 allows a DST investment to be used as a replacement property in a 1031 Exchange. For this reason alone, they can be used to deliver significant tax benefits to investors.

Other potential benefits are described below.

The Ability To Close Quickly On a 1031 Exchange Replacement Property

In a 1031 Exchange, IRS rules dictate that investors have just 45 days to identify a replacement property and 180 days to close on the acquisition of it. Competition for the best replacement properties can be significant and investors may find themselves in a situation where they have to “settle” for a suboptimal property because they have to meet the required time frame.

Delaware Statutory Trusts are widely available, are offered in all property types (multifamily apartment buildings, office buildings, retail, or industrial) and the transaction can be closed quickly to eliminate concerns about meeting the required acquisition deadlines.

Institutional Grade Properties

Typically, DSTs are used to acquire institutional quality assets that individual real estate  investors could likely not afford on their own. Continuing the example above the hypothetical investor could use their $500,000 gain to purchase the entirety of a small shopping center. Or, they could use it to purchase a fractional share of an institutional quality grocery store anchored retail asset that has an excellent location and high quality tenants on long term leases.

Diversification and Low Minimums

Typically, DSTs have a relatively low minimum investment requirement, usually ~$25,000 – $50,000. This fact, combined with a fractional ownership interest model means that investors can use them to spread their investment capital over a number of different properties and locations instead of buying just one.

In our example, the investor could take their $500,000 gain and use it as a down payment on a single property. Or, they could spread it across 10 different properties ($50,000 each) that have different tenants, different locations, and different risk profiles. This additional diversification can lower the overall risk profile in a real estate investment portfolio.

Passive Income

In a typical DST structure, investors provide capital, but all of the hard work of acquisition, due diligence, and property management is done by the DST deal leader.

The result of this structure is that DST investors get passive income/distributions, which provides the benefit of real estate ownership without the hassle of actually managing the property.

Estate Planning

DST investments can also be useful for estate planning purposes because they passed to the next generation at a stepped up cost basis, which can reduce taxes paid on inheritance.

While these DST benefits can be significant, these types of real estate investment do not come without risk. When evaluating a potential DST purchase, investors should weigh these benefits against the following risks.

DST Risks

Lengthy Holding Periods and Illiquidity

In order to have the time to execute their business plan, DSTs require lengthy holding periods, often five to ten years or more. As a result, these are not liquid investments. If real estate investors need to sell their shares at any time during the required holding period, they may be unable to do soo or be forced to sell at a significant discount.

No New Investors or Capital

Once the initial round of capital has been raised and the private placement is closed, DST rules do not allow any new investors or capital to be raised. As a result, they typically carry higher than normal operational reserves and may have to pay for large, unexpected expenses out of normal cash flow.

In either case, the net result is the same which is that these requirements may erode investor returns.

Lack of Control

Passive income is a double edged sword – one side is a benefit while the other is a risk. In return for their passive investment, investors have no operational control over the property. This means that all major decisions are made by the DST sponsor and investors have no say in them.

Fees

In return for their stewardship of the investment, DST sponsors charge a number of different fees. For example, they may charge an acquisition fee, asset management fee, or disposition fees. The sum total of these fees may chip away at overall investment returns.

Access

Finally, DST investments are only available to “Accredited Investors” who meet certain income and/or net worth requirements. As a result, they are not available to everyone, which can be a major drawback.

So, Are DSTs A Good Investment?

Given the risks and benefits, the next most logical question is, are DSTs a good real estate investment? The short answer is, it depends on each individual investor’s needs and preferences.

For individuals who have a long term time horizon, a significant gain to defer, and a desire for a passive investment vehicle, they can certainly be a very suitable investment.

At the other end of the spectrum, DSTs may not be a good investment for individuals with a short term time horizon, need for liquidity, and desire to be actively involved in the operation of the investment.

The broader point is this. The question of whether a DST is a good investment is not the right one to be asking. The better question is, are DSTs a suitable investment? To answer this one, each investor should consider their own individual needs and preferences and make an investment decision based upon them.

DSTs & Investing Through a Private Equity Real Estate Firm

A private equity firm may or may not be involved in a DST investment. If they are, it could happen in one of two ways.

First, the private equity real estate firm could serve as the DST sponsor, which means that they are in charge of finding, financing, and managing DST properties on behalf of their investors. In addition, they are in charge of the logistics of setting up the DST structure and creating and marketing the DST offering. However, it is important to note that not all DST sponsors are private equity firms.

The other way that a private equity firm could be involved in a DST investment is in an advisory capacity. If a 1031 Exchange investor comes to them and asks for advice on how to defer taxes on the sale of property, they could work together to find a suitable DST opportunity.

Summary of DST Investments

A Delaware Statutory Trust is a specialized type of legal structure that is formed for the purpose of conducting business. As it relates to real property, it is a useful structure to allow individual investors to purchase fractional shares of an institutional grade investment property.

The major benefit of a DST investment is that it qualifies as a replacement property in a 1031 Exchange, which means that investors can allocate money to them in an effort to defer income taxes on the profitable sale of an investment property.

Other major benefits of a DST investment include: passive income, depreciation, ability to diversify an investment portfolio, relatively low minimum investment amounts, and the ability to pass them on to heirs at a stepped up cost basis.

Potential downsides of a DST investment are that they require lengthy holding periods, are illiquid, and the sponsors charge fees that may chip into overall returns.

To determine whether a DST is a good investment, investors should consider their own unique circumstances and preferences. If there are any questions about suitability, it is always a good idea to work with an investment advisor.

Want To Learn More About FNRP?

First National Realty Partners is one of the leading private equity commercial real estate investment firms in the United States. We leverage decades of expertise to find world-class, multi-tenanted assets available below intrinsic value. We seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.

If you would like to learn more about our investment opportunities, contact FNRP at (800) 605-4966 or info@fnrpusa.com.

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