One of the most highly sought after benefits of a commercial real estate investment is the opportunity for investors to reduce their income tax liability. There are a variety of ways in which this is accomplished, but one of the most popular is known as a “1031 Exchange.”
In a 1031 Exchange, real estate investors can defer capital gains taxes on the profitable sale of an investment property as long as they follow two key rules. First, they must reinvest the sale proceeds into another property of “like kind.” Second, they must identify the “replacement property” within 45 days of the sale and complete the purchase of it within 180 days.
While 1031 Exchange sounds promising in theory, finding a suitable replacement property can be surprisingly challenging. Competition for the best properties can be significant and the relatively short time window can exacerbate the challenge, which is why many investors turn to Delaware Statutory Trusts (DSTs).
In this article, we will define what a Delaware Statutory Trust is, how they work, and what fees the sponsor charges to facilitate the investment. By the end, readers will have the information necessary to determine if a DST is a suitable fit for their individual investment objectives.
At First National Realty Partners, we actively work with our investors to minimize tax liability whenever possible. To learn more about our current investment opportunities, click here.
Delaware Statutory Trusts Defined
A Delaware Statutory Trust is “a legally recognized entity that is set up for the purpose of conducting business. They are formed using a private trust agreement under which real property is held, managed, invested, administered, and/or operated for the purpose of profit.” Because there is some complexity to their creation, DSTs are set up and managed by professional real estate firms (the “sponsor”), who use their experience and expertise to select the most promising DST investment opportunities on behalf of their clients.
DSTs are a popular choice for individual investors because IRS Revenue Ruling 2004-86 states that “a taxpayer may exchange real property for an interest in a Delaware Statutory Trust without recognition of a gain or loss under section 1031, if the other requirements of 1031 are satisfied.” In other words, investors who want to defer taxes on a gain may exchange property sale proceeds for an interest in a DST under section 1031 of the internal revenue code. In doing so, they must ensure that all of the other requirements of section 1031 are met.
NOTE: DST investments are only available to accredited investors who meet certain income and net worth requirements.
Pros and Cons of DST Investment
There are pros and cons to a Delaware Statutory Trust as a replacement property in a 1031 Exchange.
Pros
The pros of investing in a DST include:
- Speed: Given the time constraints involved in a 1031 Exchange, DST investors benefit from the speed with which the transaction can be closed. In some cases, it may be just a few days, which easily satisfies the 1031 Exchange timeline.
- Low Minimums: The minimum investment for a 1031 Exchange may be much lower than the equity requirement to purchase a property outright.
- Diversification: Because of the low minimums, investors can spread their funds across multiple DST deals which helps to diversify their portfolio. Deals can be diversified by location, property type, sponsor, or size.
- Fractional Ownership: A DST investment provides fractional ownership of institutional quality assets that most investors could not afford on their own.
- Estate Planning: For tax purposes, DSTs are useful in estate planning because they can be passed to beneficiaries at a stepped up cost basis.
While these benefits can be significant, they must be weighed against the potential downsides of a Delaware Statutory Trust investment, which include:
- Investment Structure: A DST investment does not purchase a share of a property directly. Instead, it purchases a beneficial interest in the trust that owns the property. This arrangement adds some legal complexity to the transaction.
- Liquidity: DST investments are not liquid. In many cases, investors are required to make a five to ten year commitment, during which time their capital is not accessible. In certain extreme circumstances, investors may be able to sell their shares, but will likely have to do so at a steep discount.
- Control: Individual investors have no say in the day to day management of the DST property. Management decisions are made by the transaction sponsor.
- Fees: There are a number of fees involved with a DST investment, which may make them more expensive than similar investment options.
On this last point, the fees, there can be a material impact on investment returns. As such, they are worth a detailed examination.
Delaware Statutory Trust Fees
To understand DST fees, it is first necessary to understand the DST structure.
There are two major groups involved in a DST investment, sponsors and investors. The sponsor is a professional real estate company who is responsible for creating the trust, finding suitable investment properties, arranging financing for their purchase, and handling all property management tasks once the purchase is complete. The investor role is passive. They provide capital and leave the rest up to the sponsor.
Because the sponsor does so much work, and fronts so much of the required capital, they charge fees to finance the effort required to get a DST investment off the ground. Generally, there are five types of fees that investors should be aware of.
Initial Fees
To finance all of the work that goes into setting up the trust as a separate legal entity, finding potential properties, performing due diligence on them, and creating the investment marketing materials, sponsors charge an initial fee to recoup their investment. The fee varies by deal, but typically ranges from 2% – 10% of invested equity.
Closing Costs
There are costs associated with getting a deal closed. These can include fees charged by the lender and fees that must be paid to brokers and for facilitating the transaction. The sponsor may pass these on to individual investors at closing.
Disposition Fees
Just as there are costs for acquiring a property, there are also costs for selling one. These include fees paid to the listing broker and the buyer’s representation as well as those paid to lawyers to dissolve the trust.
Management Fees
There are two types of management fees, property and asset. Property management fees are those paid to finance the activity required to run the property on a day to day basis. In many cases, these fees are passed through to a third party property management company. In others, they are kept by the DST sponsor because they manage the property themselves.
An asset management fee may be charged to finance the work of managing the asset. These activities include things like investor reporting and tax filings.
Capital Expenditures
Under IRS rules, DSTs can only raise capital once. In other words, if there is an unexpectedly large expense during the hold period, DSTs cannot go back to investors to raise capital for it. The cost must be paid from operating capital.
For this reason, DSTs carry higher than normal operating reserves, much of which are financed with money raised from investors.
Sales Commissions
Often, DST equity is sourced through existing broker dealer networks and/or registered investment advisors. Commissions must be paid to these firms for their work to source capital.
It is important to remember that fees can vary widely by deal. But, to provide helpful context, the total upfront cost of a DST investment can range from 10% to 18% of invested equity.
DST Fees & Private Equity Real Estate
For individual investors seeking passive cash flow from commercial real estate investments, DSTs and private equity are both potential avenues to achieve this outcome. Both types of investments also involve fees.
When comparing DST and private equity investment opportunities, individual investors must carefully review the fee structure for each type of investment to ensure they are making an accurate comparison. When performing this analysis, it is especially important to note how fees are charged. In some cases, the fee could be charged on the amount of the investment. In other cases, they could be charged based on the total deal size. Whatever the structure, fees can impact investment returns so it is important to understand exactly what they are, how they are charged, and the amount for each.
Summary of Delaware Statutory Trust Fees
A Delaware Statutory Trust is a specialized type of investment company formed for the purpose of real estate investment. As an investment vehicle, a Delaware Statutory Trust is popular with individual investors because it qualifies as a replacement property in a 1031 Exchange.
Potential benefits of a DST investment include: diversification, passive income, and a fractional interest in an institutional quality asset.
Potential downsides of a DST investment include: illiquidity, and no decision making power for individual investors.
Because DST ownership is facilitated by professional real estate companies, investors must pay fees to gain access to them. Potential fee types include: initial fees, closing costs, property management, and sales commissions.
DSTs are often compared to private equity investment opportunities. In doing so, it is important that investors carefully review the fee structure for each to determine which has the highest potential return. Fees are usually described in the prospectus and/or offering memorandum for each investment.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well 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 are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
