Key Takeaways

  • A profitable real estate investment cani be a double edged sword. A profitable exit is always welcome, but it can come with a big tax bill.
  • Sophisticated investors actively seek out ways to defer capital gains taxes. One of these strategies is through the use of a Delaware Statutory Trust (DST).
  • A DST is a specialized type of entity that is set up for the purpose of buying and holding commercial real estate assets. A 2004 IRS Revenue Ruling allows taxpayers to exchange real property “without the recognition of a gain or loss” into a DST.

When commercial real estate investors sell an investment property for a gain, they are required to pay taxes. And when the gain is big enough, the tax bill can be significant. For this reason, many investors actively seek out strategies to defer capital gains taxes. The most common strategies are a 1031 Exchange or a Qualified Opportunity Fund, and these can be highly effective under the right circumstances. However, there is a lesser known, but equally effective, tax-deferral vehicle known as a Delaware Statutory Trust (DST), and it is the subject of this article.

Delaware Statutory Trust – Defined

A Delaware Statutory Trust is defined as “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.” DSTs are set up and managed by professional real estate firms, who use their experience and expertise to select DST investment opportunities on behalf of their clients. 

In August of 2004, the Internal Revenue Service (IRS) ruled (Revenue Ruling 2004-86) 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 looking to defer taxes on a gain may exchange property sale proceeds for an interest in a DST under section 1031, which is the same code that describes a 1031 Exchange. In doing so, they must ensure that all of the other requirements of section 1031 are met.

Investing in a Delaware Statutory Trust

To invest in a DST, there are three steps that need to be completed by investors:

  1. Sell the relinquished property: In order to have a taxable gain, the property must first be sold. 
  2. Look for a DST Investment: DST properties are offered by a number of different investment managers and private equity firms. The easiest place to start is with a simple internet search, and potential Delaware Statutory Trust sponsors should be evaluated on their tracked record, investment offerings, and fees.
  3. Complete the Investment: With a suitable sponsor identified, the final step is to complete all of the necessary paperwork and transfer the necessary funds. It should be noted that DST real estate investments may only be available to accredited investors who meet certain income and net worth requirements.

Once the investment process is completed, DST investors may realize a number of significant benefits.

Benefits of DST Investment

Aside from the tax benefits, there are five significant ways that DST investments can be beneficial:

  1. Passive Income: DST investments are managed by a professional firm, which means that individual investors can collect passive income produced by the property.
  2. Diversification: DST investments are offered in a variety of asset classes—such as office, shopping centers, and multifamily—and in a variety of locations, which enables investors to find an option that is suitable for their risk tolerance and time horizon.
  3. Quality: DST investments provide a fractional interest in institutional-quality assets that would be otherwise unaffordable for individual investors.
  4. Planning: DST investments can be an effective estate planning tool since they are easily divisible by heirs, who can inherit them at a stepped-up cost basis.
  5. Low Minimums: The minimum investment for a DST is much lower than a traditional private equity offering, allowing investors to diversify their funds across multiple deals.

While the benefits of a DST investment can be significant, such a strategy is not without risk.

Risks of a DST Investment

Like any investment, there are a number of risks that potential DST investors should be aware of:

  1. Liquidity: DST investments typically require a holding period of 5-10 years, during which time the investment is illiquid. If the money is needed at some point during the holding period, investors may or may not have access to it.
  2. Control: DST investors have a passive role in the investment. The ownership structure is such that they have little-to-no say in day-to-day property management nor the decision making process. If there is a disagreement between the manager and investors, the manager will prevail.
  3. Capital: Per IRS requirements, a DST may not raise new capital once the funding round is closed. As such, if an unexpected big-ticket repair is needed, it must be paid for out of reserves or operating income. This can have a material impact on investment performance.
  4. Fees: DST investment managers charge fees for their administration of the investment. These fees vary by manager, but can impact overall investment returns.

How is a DST Investment Different Than a 1031 Exchange?

The requirements for a Delaware Statutory Trust and 1031 Exchange both derive from Section 1031 of the Internal Revenue code, but there is one major difference.

In a 1031 Exchange, an investor purchases a property directly through an LLC or through some other type of arrangement, such as Tenants In Common (TIC). As the property owner, the investor has a say in management decisions as well as the exit strategy.

In a Delaware Statutory Trust, investors are not buying a property. Rather they are buying shares in a trust that owns a property, and their shares entitle them to a portion of the cash flow produced by the underlying property.

Both of these investments can have a significant impact on an individual’s tax returns and tax liability. For this reason, interested investors should seek tax advice from a qualified real estate attorney or CPA prior to committing funds to one or the other.

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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