For individual real estate investors, there are a number of strategies that can be used to defer capital gains taxes on the profitable sale of an investment property. One of the most popular is known as a “1031 Exchange” which allows investors to defer taxes on the sale as long as they reinvest the proceeds into a “replacement property” that is considered to be “like kind” to the sold property.
Under IRS rules, the replacement property must be identified within 45 days of sale and the transaction must be closed within 180 days. While the 1031 Exchange tax benefit can be significant, it is common for real estate investors to experience difficulty finding a suitable replacement property in such a short period of time. Enter the Delaware Statutory Trust (DST).
In this article, we will define what a DST is, how they work, why they can be beneficial to individual investors, and how they are structured. By the end, readers will have the information needed to determine if a DST is a suitable fit for their own 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 real estate investment opportunities, click here.
What is a Delaware Statutory Trust?
Under Delaware law, a DST is a specialized type of trust that is formed for the purpose of conducting business. They are formed with private trust agreements under which real property is “…held, managed, administered, invested, and/or operated.”
The reason that DSTs are popular with real estate investors seeking tax deferral is that IRS Revenue Ruling 2004-86 states that a DST investment qualifies as a “like kind replacement property” in a 1031 Exchange. Practically, this means that individual investors can defer capital gains tax liability by reinvesting the proceeds from a profitable sale into a DST.
NOTE: DST investments are only available to accredited real estate investors, who meet certain income and net worth requirements.
How Are DST Investments Structured?
Setting up a DST requires a significant amount of commercial real estate expertise and a high degree of familiarity with the legal rules that govern this type of real estate investment. As such, a typical DST investment structure involves two parties: the sponsor and the investors.
A typical DST sponsor is a real estate investment company who leverages their experience, relationships, and resources to organize and market the DST offering. In most cases, this effort involves:
- Creating the DST structure and filing the necessary paperwork with regulatory authorities
- Finding, analyzing, and acquiring a DST property
- Preparing the marketing materials for the DST offering and marketing it to accredited real estate investors through the traditional broker dealer network.
Once the purchase transaction is closed, the sponsor will arrange for a related subsidiary to act as the master tenant responsible for all leasing and property management/asset management activities.
In short, the DST sponsor does all of the upfront work to set up the investment entity and to find a suitable property to purchase. But, to complete the purchase they need capital, which is where real estate investors come into play.
The primary role of the DST investor is to provide equity capital. They have no say in the day to day management of the real estate.
From a legal and structural standpoint, it is important that DST investors understand that their capital does not purchase a share of the underlying property directly. Instead, their funds purchase a “beneficial interest” in the trust, which holds title to the property.
In return for their investment, DST investors receive periodic distributions from the trust. Upon sale, they will receive their share of the net sales proceeds after any debt has been paid off.
Pros and Cons of The DST Structure
There are pros and cons of the DST ownership structure. The pros include:
- Expertise: Sponsors have the expertise, experience, and industry relationships needed to correctly set up the DST and find suitable properties for real estate investors.
- Income: Because sponsors do all of the work to find, finance, and manage the property, DST investors are the beneficiaries of passive cash flow.
- Minimum Investment: For investors, the minimum investment required for a DST is often lower than other commercial real estate assets. As a result, available investment capital can be spread across multiple DST properties, which lowers overall risk and increases portfolio diversification.
- Fractional Ownership: For real estate investors, the DST structure allows them to have fractional ownership of high quality assets that they likely could not afford on their own.
- Speed: Remember, 1031 Exchange investors have just 45 days to identify their replacement property and 180 days to purchase it. DST investments can be closed as quickly as 5 days, which easily satisfies this time requirement.
While these benefits can be significant, they must be weighed against the potential cons of the DST structure. They include:
- Control: Real estate investors have no say in the day to day management of the property. If there is any disagreement about a major decision, the sponsor will prevail.
- Liquidity: In order to properly implement the property’s business plan, sponsors need time. As such, they typically require five to ten year hold periods, during which time an investor cannot access their capital. In extreme circumstances, the investor may be able to sell their shares, but at a significant discount to value.
- Interest Rates: DSTs are income driven real estate investments, which make them particularly sensitive to interest rate changes.
- Regulatory Risk: Finally, the popularity of DSTs is closely tied to the fact that they can be used as a replacement property in a 1031 Exchange. Changes to the internal revenue code could materially impact the “invest in DSTs for tax purposes” narrative.
Potential DST investors should complete their own due diligence on the DST structure and the relative risks and benefits to determine if this investment type is suitable for their own real estate objectives.
DSTs & Private Equity Real Estate
DST investments are offered by a wide variety of real estate investment companies, including private equity firms. As part of their due diligence process, DST investors must research the firm’s structure and how it can impact the success of the investment. If the sponsor happens to be a private equity firm, they typically bring significant value to the deal in the form of:
- Real estate industry relationships to find the best properties at the most attractive prices.
- Operational expertise to create the separate legal entity for the DST, underwrite the property, negotiate a favorable price, and choose the right property management partners.
- Market expertise to know when to sell the property and for how much.
Again, the organizational structure of the DST sponsor can have an impact on the success of the DST investment so it is important that investors take the time to understand it to ensure they are comfortable with it.
Summary of the Delaware Statutory Trust Structure
A Delaware Statutory Trust is a specialized type of company formed for the purpose of real estate investment. As an investment vehicle, they are popular with individual investors because they qualify as a replacement property in a 1031 Exchange.
DSTs have a two tier structure. The real estate sponsor is responsible for organizing the DST, finding the property, financing it, and managing it. Investors provide equity capital, but are otherwise passive partners.
Benefits of this DST structure include passive income, fractional interest in high quality properties, and tax deferral.
Potential downsides of the DST structure include illiquidity, lack of operational control, and regulatory risk.
DST sponsors may or may not be a private equity firm. If they are, they can add significant value through their real estate industry relationships, operational expertise, and market knowledge.
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 email@example.com for more information.