Selling a real estate investment for a profit presents a good news/bad news scenario for most investors. The good news is that a profit was realized, which is always welcome. The bad news is that the profit comes with a tax bill that is proportionate in size. Fortunately, Internal Revenue Service (IRS) rules provide investors with a number of strategies to defer this tax bill, one of which is to invest in a Delaware Statutory Trust (DST).
In this article, we will describe what a Delaware Statutory Trust is, how they can be used to defer capital gains taxes, and the role that a sponsor plays in facilitating the investment. By the end, investors will have the information needed to determine if a DST investment is a good fit for their personal real estate preferences.
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 Explained
A Delaware Statutory Trust is a trust that is set up for the purpose of conducting business. They are formed with private agreements under which real, tangible, or intangible property is “…held, managed, administered, invested, and/or operated.”
With regard to tax deferral strategies, a DST Investment qualifies as a “like kind” replacement property in a 1031 Exchange under IRS Revenue Ruling 2004-86. For individual real estate investors, this means they can defer the capital gains tax liability from a profitable sale by reinvesting the proceeds into a DST (NOTE: DST investments are only available to accredited investors, who meet certain income and net worth requirements). For this reason, DSTs are popular investment products. But, there is a significant amount of administrative effort that goes into creating and managing them for the duration of the investment’s holding period. This is more work than any one real estate investor can handle so it is often left to the transaction “sponsor.”
What is the Role of a DST Sponsor?
A DST sponsor is tasked with the work of organizing the trust, filing the necessary paperwork, and creating the necessary systems and processes to find, purchase, and manage institutional grade commercial properties. They also need to find DST investors to fund the property purchases.
Given the advisory services they offer, and because they play such a critical role in the success of the transaction, it is important that investors perform a significant amount of due diligence on their sponsor to ensure they have the experience and credentials to successfully manage the investment.
Things to Remember About DST Sponsors
Potential DST sponsors should be evaluated on five dimensions:
- Size: DST sponsors vary greatly in size, but the largest ones like Inland Capital or Pasco have the scale and reach to offer a wide variety of investment opportunities. For individual investors, larger firms are the best bet for finding a suitable DST offering.
- Strategy: DST Sponsors may pursue different strategies. For example, some may focus on multifamily investment properties while others may pursue office buildings or industrial assets.
- Experience: DST sponsors with significant commercial real estate experience offer a better chance of a profitable outcome than one that is new or inexperienced.
- Fees: All DST sponsors charge fees, but the amount and structure can vary by sponsor. For this reason, investors need to evaluate DST fees as part of their due diligence to ensure they are making an accurate comparison.
- Scale: Larger firms have the scale necessary to drive operational efficiencies in the investment origination and property management processes. As a result, the DST returns may be slightly higher due to lower operational costs.
Individuals interested in investing in DST properties should also consider the minimum investment required, the DST structure, and the time commitment required by the sponsor. Again, these can vary by transaction.
Pros and Cons of Working With a DST Sponsor
Lile any real estate investment opportunity, there are pros and cons to working with a sponsor to make a DST investment. The pros include:
- Taxes: The primary benefit of a DST is the tax deferral associated with using it as a replacement property in a 1031 Exchange. Working with a DST sponsor is a good way to find one quickly.
- Property Quality: DST sponsors help DST investors gain fractional ownership of institutional quality commercial properties.
- Cash Flow: Because DST sponsors handle day to day property management, DST investors can earn passive income from regular distributions funded by the income generated by property leases.
- Diversification: Given their relatively low minimum investment amounts, DST investors can purchase an interest in multiple properties, with multiple sponsors, which can diversify their portfolio across property type, location, market, and size.
- Liability: DST investors benefit from limited liability on a personal level because DST sponsors set up the property in a separate legal entity with a defined ownership structure. In addition, many DST transactions are financed with non-recourse debt, which further limits investor liability.
- Estate Planning: As an investment vehicle DSTs can be passed easily to beneficiaries upon death. In some cases, DST sponsors can assist in this transfer.
But, there are potential downsides too. They include:
- Illiquidity: DST sponsors often require that real estate investors make a five to ten year commitment. During that time, their investment has no liquidity.
- Fees: DST sponsors do not work for free. They charge fees to pay for the administrative overhead required to find, finance and manage the DST property.
- Involvement: Individual investors have no say in the day to day management decisions of a DST property. All management responsibilities are handled by the DST sponsor and if there are any disagreements, the sponsor will prevail.
- Additional Capital: Once the deal is closed, DSTs are not allowed to raise additional capital. Major repair and maintenance costs must be paid from reserves. For this reason, DST sponsors carry higher than normal operating reserves, which can impact the investment’s overall profitability.
Potential DST investors should weigh the pros and cons of a DST investment to determine if they are a good fit for their own objectives. But, DST rules can be complex, which is why it is helpful to leverage a sponsor’s experience and expertise. In addition, it is always a best practice to speak with an investment advisor or CPA to ensure there is proper understanding of DST tax benefits and the rules that must be followed to realize them.
DST Sponsors & Private Equity Real Estate
It is important to note that the boundaries between a DST sponsor and a private equity firm can be a bit blurry.
As the name suggests, a private equity firm is a private company that invests in the equity of other companies, including those that own real estate. Private equity firms offer a wide variety of investment vehicles that may or may not include DST options. If they do, it is the private equity firm that acts as the investment sponsor.
Conversely, the DST sponsor may or may not be a private equity firm. If they aren’t, it doesn’t necessarily mean that they are unqualified. It just means that their organizational and capital structure is different. If they are, it may be good news because private equity firms tend to have a significant amount of financial and operational expertise which means they can add significant value to DST investments.
Summary of Delaware Statutory Trust Sponsors
Under Delaware laws, a Delaware Statutory Trust is a specialized type of investment entity that is set up for the purpose of conducting real estate business. They are formed with private agreements under which real property – tangible, or intangible – is “…held, managed, administered, invested, and/or operated.”
Delaware Statutory Trusts are popular with investors seeking to defer taxes on the profitable sale of a real estate investment because they qualify as a “replacement property” in a 1031 Exchange.
But, the rules and processes that must be followed to facilitate a DST investment are complicated. For this reason, they are typically managed by a “sponsor.”
The sponsor’s role is to find suitable DST properties, create the trust, raise the necessary capital, and manage the property once it is purchased. They play an integral role in the transaction and their stewardship is a key component in its success.
The benefits of working with a sponsor include access to institutional quality investments and passive income. But, the potential downsides include the fees that they charge, and the time commitment that they require.
Depending on the investment, the sponsor may or may not be a private equity firm.
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.
