Key Takeaways

  • A Delaware Statutory Trust is a specialized type of commercial real estate investment entity that is set up for the purpose of conducting business. For individual investors, there are four benefits that could be realized from investing in one.
  • In Revenue Ruling 2004-86, the IRS allowed that investors could allocate investment capital to a Delaware Statutory Trust without recognition of a gain or loss. This allows investors to defer capital gains taxes on a sale indefinitely.
  • A DST can provide individual investors with access to an institutional quality asset that they could likely not afford on their own.

A Delaware Statutory Trust is a specialized type of commercial real estate investment entity that is set up for the purpose of conducting business. Such entities are formed using a private trust agreement under which real property is held, managed, invested, administered, and/or operated for the purpose of profit.

In most cases, DSTs are set up by an investment management or private equity firm and used as the vehicle to purchase commercial real estate assets. In a typical structure, individual investors have an opportunity to purchase a beneficial interest in the trust which entitles them to a share of the cash flow produced by the underlying property. 

There are a number of benefits to a typical DST investment, but there are four that stand out above all others.

Benefit #1: Tax Deferral 

The Delaware Statutory Trust structure is not new, but an IRS ruling on them propelled them into the spotlight as a way to defer taxes on a capital gain. Specifically, 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 all other requirements of section 1031 are met.”

In other words, an individual who has realized a gain on a commercial real estate asset can exchange the sale proceeds into a Delaware Statutory Trust without recognition of the gain for tax purposes. This type of tax benefit tends to be very attractive to property owners who have owned an asset for a long period of time over which there has been significant price appreciation. Rather than sell the investment property and pay capital gains taxes, they can sell the property and place the proceeds into the trust while deferring the tax bill in the process. Further, it is possible to repeat this process over and over again, which means a Delaware Statutory Trust 1031 exchange can defer capital gains taxes indefinitely.

Benefit #2: Asset Quality

In a Delaware Statutory Trust, investment managers pool money from multiple accredited investors and use it to purchase an institutional grade asset that any one investor could not afford on their own. For example, a DST property could be a Class A, 500-unit multifamily property in a prime location, or it could be a high rise office building in the central business district of a major city. These types of trophy properties are only affordable for the most well-funded institutional investors. Many individuals may find it to be more advantageous to own a fractional interest in this type of asset rather than a 100% share of a lower quality property.

Although the interest is fractional, the scale of a large institutional property may prove to be more beneficial in the long run when compared to a much smaller asset.

Benefit #3: Low Minimums and Diversification

The typical minimum investment requirement in a DST is $100,000, which is lower than many of the investment alternatives. Investors with a big gain can spread their funds across multiple investments, property types, asset classes.

For example, an investor with a $500,000 gain could invest in a multifamily property in addition to an office building, industrial complex, and retail center. They could also further diversify their holdings if these properties were in multiple locations. 

Benefit #4: Estate Planning

For investors concerned about their beneficiaries, DST investments can be an effective estate planning tool for three reasons. First, heirs inherit these investments at a stepped-up cost basis, which means that beneficiaries do not pay capital gains tax on the accumulated appreciation from the time the asset was purchased to the time the holder passes away. Second, if there are multiple heirs, Delaware Statutory Trust investments are easily divisible. Finally, should investors want to leave their holdings to charity, they can do so easily with a DST. 

This is because a Delware Statutory Trust is a passive investment and the charity does not have to assume management of the underlying property. Instead, they can continue to leave property management decisions to the investment manager while reaping the benefit of the passive income. 

Delaware Statutory Trust Risks

While the benefits of a Delaware Statutory Trust investment can be significant, they are not without risk. Like any real estate investment, they are subject to market risk as well as leasing risk. But there are two risks in particular that are unique to DST investments and deserve consideration.

First, IRS rules for the Delaware Statutory Trust structure do not allow them to raise additional capital once the investment has been funded. So, if there is a surprise repair that has a major cost—like the electrical system—it has to be paid for from reserves or operating income. If the cost is substantial enough, it can absorb years of profits. For this reason, it is critical that DST investors ensure the property carries adequate reserves to address this potential issue.

Second, DST investments are illiquid and subject to fees. In many cases, the investment manager requires funds to be committed for 5 to 10 years, during which time the funds cannot be accessed. If an emergency arises and the investor needs his or her money, the investor may have to liquidate at a significant discount to value. In addition, Delaware Statutory Trust managers charge fees for their administration of the investment. The actual DST fees vary from one manager to another and they can have a material impact on returns, so they must be reviewed carefully.

Final Thoughts 

DST investments are not suitable for all investors. They are most appropriate for individuals looking to defer a big capital gain through a passive investment option. Before allocating capital to one, investors should consult with a qualified real estate attorney and/or CPA to ensure suitability.

Interested In Learning More?

First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, 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 Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.

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