The depreciation deductions for a DST are based on the cost of the underlying real estate assets. Investors can claim depreciation deductions for the remaining useful life of the real estate assets. Investors who sell their interest in a DST may have to recapture any depreciation deductions that they have claimed. Let’s go through the details of how all of this works.
Real Property Depreciation
Investing in a rental property can provide a number of tax advantages. After writing off expenses, investors are left with their net profit. However, they aren’t done because depreciation must be taken as well.
Depreciation is a noncash expense because it doesn’t directly impact cash flow or the investor’s bank account. It does impact net profits on paper. Depreciation reduces net profits. Some investors may find they are operating at a loss because of depreciation. Yet, they still have positive cash flow.
When depreciation creates a loss for the year, the investor may not owe any taxes on their real estate investment. This is one of the main attractions that draws many investors to real estate.
DST Depreciation
Finding a replacement property for a 1031 exchange (i.e., like-kind exchange) can sometimes seem impossible. A DST can provide a simple path to exchange property since investors only need to find a DST that fits their objectives.
When an investor has depreciation remaining on their relinquished property, it is carried over to their replacement property. The same is true for DSTs. Any depreciation on the relinquished real property is carried over into the DST, where the investor is able to continue their depreciation schedule.
Some investors may not have any remaining depreciation on their relinquished property. In this case, their basis is carried over into the DST.
Depreciation Recapture
Depreciation recapture occurs when an investor takes depreciation on a property and then later sells the property. Some of that depreciation must be paid back in the form of a depreciation recapture tax.
The same is true of DSTs. When the DST investment cycle ends, its properties are sold. The selling of these properties can create a depreciation recapture tax for investors.
There are ways that investors in a DST can avoid depreciation recapture at the end of the DST’s investment cycle. One method is to 1031 exchange into another DST. The same 1031 exchange rules and deadlines will apply.
Another method is to exchange DST interest for real property. Going this route means the investor will need to get involved in property management.
DST interest can also be exchanged into stocks via a 721 UPREIT (Umbrella Partnership Real Estate Investment Trust) exchange. This exchange is the end of the road for tax deferral, though. Investors will need to sell their UPREIT shares to get out of the UPREIT, which will trigger a taxable event.
DST taxation is a complex topic. It’s best to seek a tax professional if you have any DST tax-related questions.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
No public market currently exists, and one may never exist. DST programs are speculative and suitable only for Accredited Investors who do not anticipate a need for liquidity or can afford to lose their entire investment.
Costs associated with a 1031 transaction may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
