An investment in a Delaware Statutory Trust is a popular choice for individuals looking to defer capital gains taxes on the profitable sale of an investment property. But, the capital gains tax deferral is just one piece of the DST taxation puzzle.
In this article, we are going to describe what a Delaware Statutory Trust is and provide specific detail about the tax implications of investing in one. By the end, readers will have the information needed to decide if a DST investment is suitable for their personal investment objectives.
At First National Realty Partners, we leverage years of expertise and hundreds of transaction repetitions to minimize a property’s tax liability for our investors. To learn more about our current investment opportunities, click here.
Delaware Statutory Trusts Explained
A Delaware Statutory Trust is a specialized type of trust, formed under Delaware law, for the specific purpose of conducting business. They are a separate legal entity, formed with private trust agreements, under which real property is “…held, managed, administered, invested, and/or operated.”
Investors like DSTs because they can provide passive monthly income, portfolio diversification, and generally have low minimum investment requirements when compared with other types of commercial real estate investment.
Perhaps most importantly, Delaware Statutory Trust properties are popular with individual investors because IRS Revenue Ruling 2004-86 states that a DST investment qualifies as a “like kind replacement property” in a 1031 Exchange. This means that individual investors can defer capital gains taxes on the profitable sale of a property by reinvesting the proceeds into a DST. The strategy can yield substantial tax benefits over time, but it doesn’t mean that the income and profits earned from a DST are also tax free. They are not. For this reason, it is important for DST investors to understand the tax implications of a Delaware Statutory Trust investment beyond the deferral benefits offered by a successful 1031 Exchange.
NOTE: DST investments are only available to accredited investors, who meet certain income and net worth requirements.
Delaware Statutory Trust Taxation
There are four scenarios in which investors should be aware of the tax implications of a DST investment: income and capital gains, depreciation, cost basis, and future 1031 exchanges. Each of these are discussed in detail below.
Income & Capital Gains
DST investors own a beneficial interest in a trust, which owns a piece of commercial real estate. That piece of commercial real estate produces a regular stream of income and, if the investment is successful, a big capital gain when the property is sold at the end of the holding period.
At the end of each tax year, DST real estate investors receive two documents from the transaction sponsor:
- An operating statement that details their pro rata share of the property’s rental income and expenses
- A 1099 tax form, which details the dividend income received from the real estate investment. The information from the 1099 is plugged into Schedule E of the investor’s tax return.
In other words, the income and capital gains received from the DST is mixed with an investor’s other sources of income and deductions to determine their income tax liability in a given year.
Depreciation is an accounting concept that allows an investor to expense a portion of a property’s value each year to account for its physical deterioration. Accumulated depreciation forms the “cost basis” for a property, which is an important number for tax purposes.
When a Delaware Statutory Trust investment is used as a replacement property in a 1031 Exchange, the investor’s cost basis from the “relinquished property” carries forward into the new DST property in which they purchase a fractional interest. If the investor still had basis in the relinquished property (i.e. it wasn’t fully depreciated), or if they purchased DST properties with a greater value than what they sold, they can use depreciation to reduce the amount of taxable income produced by the property.
Tax Treatment of Future 1031 Exchanges
There is no limit to the number of 1031 Exchanges that an investor can complete. In theory, they could be completed indefinitely for maximum tax deferral.
If a DST investment is successful and the property is sold for a profit, an investor is able to use the sale proceeds and reinvest them again into another DST offering to extend their tax benefits.
Buying Properties of Equal or Greater Value
In order to successfully complete a 1031 Exchange, there are a number of 1031 exchange rules that investors must follow. One of them states that the value of, and equity in, the replacement property must be of equal or greater value than the relinquished property.
For example, if the relinquished property has a value of $1MM and a mortgage of $500M, there is $500M in equity. So, this means that the value of the replacement property must be at least $1MM and the investor must invest all $500M equity earned from the sale of the relinquished property. Any differences between these two values may trigger a taxable event.
It is critically important to note that 1031 Exchange rules, and the internal revenue code in general, can be very complex and may be applied differently to each individual taxpayer’s situation. For this reason, it is always a good idea to consult a CPA, investment advisor, and/or qualified tax attorney before making major investment decisions.
DST Tax Returns
When an individual makes a DST investment, there are two things that must be considered regarding completing their annual tax return.
First, as described above, all of the income, capital gains, and distributions earned from the investment are reported on a 1099, which is filed as part of each investor’s individual tax return. The exact tax liability associated with this cash flow may be different, depending on each individual’s tax situation.
Second, it is common for a DST property to be located in a state that is different from the one the investor lives in. If this is the case, and that state requires a separate income tax filing, it is likely the investor may have to file a tax return for that state. For example, if an investor lives in New Jersey, but the multifamily DST property is located in New York, it is possible they may have to file a New York state income tax return. If an investor has multiple DST properties, in multiple states, they may have to file multiple state tax returns. This complexity again underscores the importance of working with a CPA to ensure all tax obligations are met.
Delaware Statutory Trust Tax Treatment & Private Equity Real Estate
Although there are structural differences between DST investments and those offered by private equity firms, there are some similarities between how they are taxed.
For example, income and capital gains produced by the underlying commercial properties are treated as ordinary income and subject to income tax and capital gains are subject to capital gains tax.
But, each investor’s tax situation is different and the amount of tax due is also likely to be different. For example, one DST/private equity investor may live in Florida where there is no state income tax while another may live in California, which has a substantial state income tax. As such, it deserves mentioning one more time that working with a CPA can help to navigate the complexity of the tax code and its treatment of DST investments.
Summary of DST Taxation
A Delaware Statutory Trust is a specialized type of legal entity that is formed for the specific purpose of owning, managing, or investing in real estate. In the DST structure, investors are able to gain fractional ownership of institutional quality assets that qualify as a replacement property in a 1031 Exchange.
Given their unique legal structure, there are several scenarios in which DST investors should consider their potential tax liability: income and capital gains, depreciation, 1031 Exchanges, and the requirement to buy a property of equal or greater value.
At the end of each tax year, DST investors receive a 1099, which details the income earned from the investment. This information is transferred to schedule E of their tax return and it is subject to income tax.
Although their structure is different, there are some similarities between how DSTs and private equity investments are taxed.
Because every tax situation is unique, DST investors should work with a qualified CPA to ensure that all tax requirements are met with regard to their DST investment.
Interested In Learning More?
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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 firstname.lastname@example.org for more information.