Joining a Delaware Statutory Trust (DST) can offer passive exposure to real estate and potential capital gains tax deferral when used in conjunction with a 1031 exchange. For some investors, there’s always the lingering question regarding liquidity, or your ability to exit the investment and cash out. Can DST investments be liquidated early? The answer is more nuanced than a simple yes or no. While most DSTs are liquidated only after the end of the holding period, there are certain scenarios when early liquidity can happen.
Below, Realized 1031 has shared a guide to help explain these less common situations and outline alternative options for investors seeking to exit a DST position. Let’s take a closer look.
DSTs are legal trust entities that hold one or more income-generating properties. Investors purchase fractional interests in the trust and receive income proportional to their shares. Given the amount pooled by investors, DSTs usually have enough funds to acquire institutional-grade assets, such as large office buildings or hotels.
DSTs became eligible for 1031 exchanges thanks to Revenue Ruling 2004-86. However, this update also made DSTs more structured. For example, to qualify for tax-deferral benefits, DSTs must be passively managed and controlled by the sponsor—meaning investors cannot direct day-to-day operations or make decisions regarding refinancing, major improvements, or property sales.
There’s also the fact that DSTs have fixed holding periods, which are usually five to seven years long. During this time, the property is managed by a trustee or sponsor, and investors generally cannot influence major decisions or trigger liquidity. For the majority of DSTs, the end of the holding period marks the liquidity event. This scheduled disposition is the primary liquidity event for participants.
The holding periods of DSTs are typically fixed.. Plus, the fact that only the sponsor has control over the properties can make it seem like early liquidation will never be on the table. However, early liquidation is theoretically possible — but this event is rare and involves complex processes. Here are a few reasons why.
As we mentioned, DST investors have no direct control over the management, daily operations, and major capital decisions, including exit timing. Entering the DST generally means accepting that you can only liquidate by the end of the holding period. These restrictions are set in place to maintain compliance with the 1031 exchange requirements and maintain tax-deferral eligibility.
Only the sponsor or trustee managing the DST can decide whether to sell the asset early. Even then, they must act in the best interest of all investors and within the boundaries of the trust agreement. If market conditions change drastically, the sponsor may consider early liquidation. Tenants going bankrupt or the property no longer being profitable are also possible reasons. However, such scenarios are uncommon.
There are DST structures that allow limited investor input. And even so, a unanimous or supermajority decision is needed to initiate early liquidation. Having to coordinate agreements across dozens or possibly hundreds of investors can be challenging. Plus, this structure generally applies to DSTs that are not designed to comply with 1031 exchange rules. If your DST is 1031 exchange-compliant, supermajority decisions are not permitted under IRS guidelines.
DSTs, including ones that follow 1031 exchange requirements, can face early liquidation without investors needing to initiate anything. Such scenarios are rare, and they can occur under specific conditions.
Early DST liquidation is possible, but only under extremely rare circumstances. As such, investors who’d like to exit the DST must take alternative routes to do so. One option is to find a secondary market where you can sell your interests. However, DST secondary markets tend to have limited liquidity, and interests are often sold at a discount.
For DSTs nearing the end of the holding period, investors may continue the 1031 exchange to a DST with more flexible terms or shorter holding periods. While this strategy isn’t liquidation, it can offer more tailored timelines in your next investment.
The main challenge you’ll need to consider during early liquidation is the fact that it may trigger a taxable event. The IRS generally requires investors to recognize capital gains and depreciation recapture, including amounts from prior exchanges if applicable.
When you take the route of selling interests in a secondary market, you may also need to make concessions so your offer is more appealing. These compromises can include discounts, which lower your ROI.
Because of these risks, DSTs are generally suited for long-term, income-focused investors who are prepared to commit capital for the full duration of the holding period.
In theory, the early liquidation of DSTs is possible. However, there are several conditions that must be met first, and such events usually only happen because of extraordinary circumstances, not due to an investor’s requests. DSTs are structured to be long-term, passive investments, so if you need to liquidate, alternative methods like selling interests are usually the most feasible option. For this reason, investors considering DSTs should evaluate their future liquidity needs carefully to determine whether these investments align with their broader financial goals and time horizon.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Article written by: Story Amplify. Story Amplify is a marketing agency that offers services such as copywriting across industries, including financial services, real estate investment services, and miscellaneous small businesses.
Sources:
https://www.investopedia.com/articles/analyst/112702.asp
https://smartasset.com/investing/delaware-statutory-trusts-dsts