Use of Delaware Statutory Trusts for 1031 Exchanges

By Jillian Pace, CPA, Tax Manager
ASL Real Estate Group

Real estate investors have long used 1031 exchanges to defer capital gains and other taxes from the sale of “like-kind” properties. In recent years, there have been some issues with typical 1031 exchanges such as finding replacement properties, complying with the required property identification and purchase time requirements, investing all sale proceeds from the exchange, seeking diversification, etc. Real estate investors may want to consider some alternatives to typical 1031 exchanges to help avoid these types of issues. One increasingly popular alternative is the use of Delaware Statutory Trusts.

What is a Delaware Statutory Trust?

A Delaware Statutory Trust (“DST”) is a separate legal entity that is created to pool money from various investors. The DST holds title to investment real estate, and the investors of the DST own a fractional interest in the underlying assets of the trust. Most DSTs are sponsored by national real estate companies and are offered through securities brokers/dealers. The investment real estate held by a given DST can be commercial or residential and can contain one property or multiple properties. The DST is managed by an assigned trustee, so the investors have no direct control nor decision making authority when it comes to the management of their investment. Similar to a partnership or LLC, the DST will pass all income and expenses through to the individual investors of the trust.

Out With the Old, In With the New

Before the DST structure for exchanges grew in popularity, most fractional-ownership programs were structured as Tenancy in Common (“TICs”). Though DSTs and TICs have several similarities, one major difference between the two is that TICs require unanimous approval by all members for any major decision, such as selling or refinancing the property. This unanimous approval requirement started to become problematic in situations where the members could not come to a unanimous decision, hence the need to create an alternative structure to hold a fractional interest in real property.

Advantages of DSTs

  1. Investment in a DST is considered an eligible replacement property under the 1031 guidelines both when the investors initially invest and when the DST liquidates.

This is extremely beneficial in the market right now being that there is a lack of replacement properties for typical 1031 exchanges but there are many DSTs available for purchase. Due to the fact that with a DST you are purchasing a fractional interest in the underlying assets of the trust, you are able to invest the amount needed to qualify for a typical 1031 exchange. In addition, “zero income” DSTs are available to allow 1031 exchanges of highly leveraged properties.

  1. Provides the investor with the ability to purchase fractional interests in commercial-grade real estate that may otherwise be beyond their means, allowing them to diversify their portfolio.

There is a low minimum investment amount for exchanges into a DST, typically $100,000, allowing investors to purchase real estate they otherwise may not be able to afford.  Investors can diversify their portfolios since there is no limit on the number of DST investments one can acquire and each DST can potentially hold multiple properties.

  1. DSTs are managed by an assigned trustee allowing investors to be passive investors.

No active management is required by the investors, and because of the assigned trustee, they are alleviated of the typical landlord duties that usually come with a 1031 exchange such as finding tenants, dealing with property repairs and maintenance, etc.

  1. The investor’s agreement is only with the trustee of the DST as opposed to having a co-ownership agreement among other investors, such as with a TIC.

This is a good option for real estate owners that don’t want to be in business with other partners and don’t want to worry how the actions of other investors will impact their investment.

  1. DSTs may allow investors to participate in an UPREIT exit strategy.

Upon liquidation of the DST, investors may be able to exchange tax free into a partnership interest and ultimately into ownership of a REIT.

  1. The lender makes one loan to the trustee of the DST so individual investors do not need to qualify for a loan to purchase the property, unlike with a TIC where all owners need to qualify.
  2. Investors have the potential to receive recurring monthly income since the DST generally pays monthly distributions.

Disadvantages of DSTs

  1. DST transactions can be expensive.

DST transactions have certain costs that aren’t as typical to most other real estate acquisitions such as sales commissions to third-party selling groups, broker-dealer fees, and sponsor fees. These exist both when one acquires an interest in a DST as well as when the DST sells the property. In addition to these costs, there are also management fees paid to the DST sponsor, and the cost of tax compliance can be high due to the increased complexity.

  1. Increased complexity for tax compliance in year of exchange and in each year that follows.

The information provided to the investors from the trustees of the various DSTs can vary and is not provided on a typical K-1 which shows one rental income/loss number like the investor would receive from a partnership or LLC. Because a DST can hold multiple properties in multiple states, investing in a DST can trigger additional state tax filing requirements.

  1. Due to IRS requirements, the DST Trustee has limited power over the investment.

The main restrictions that can cause problems for a DST are: (1) No future equity contribution is permitted from new or existing investors, and (2) The trustee may not borrow new funds nor renegotiate existing loans. To address these limitations, most DSTs have a “Springing LLC” provision in their origination documents. If the trustee feels that their inability to execute active management over the investment may put the DST at risk of losing the property, they can convert the DST into an LLC in order to engage in active management of the entity.

  1. DSTs with debt have a limited life as most are financed with loans that are due in 10 years or less, and the DST is not able to refinance the loans.

If an investor exchanges into a DST and wants to avoid recognizing gain, they will need to continue to buy into new DSTs every few years and continue to incur purchase and sales fees. As a result, their DST investment may not show significant appreciation due to  such  fees.

  1. Because the trustee has complete control and decision-making authority, this can be potentially problematic for the investors if the trustee makes decisions they don’t want or agree with.

Contact Us

Investing in DSTs is complex. If you have any questions about the information outlined above or need assistance determining whether or not investing in a DST is the right move for you, Abbott, Stringham & Lynch’s Real Estate Group can help. For additional guidance, please call us at 408-377-8700 or click here to contact us. We look forward to speaking to you soon!