As an investor, you’re already familiar with capital gains and capital gains taxes. A capital gain is an increase in the value of a capital asset, which is generated when that asset sells. Meanwhile, capital gains taxes are the taxes you owe to the IRS from those realized capital gains from the asset sale.
But not all investments are the same. For example, mutual funds and Delaware Statutory Trusts (DSTs) are investments. But their purposes are different. So are how capital gains are treated?
Mutual funds are pool investments regulated under the Investment Company Act of 1940 (known as the “40 Act”). You buy a specific number of shares in that fund. The fund’s sponsor then combines your money with that of other investors to build and maintain portfolios that include equities, bonds, or different types of assets.
But mutual fund sponsors don’t hold those assets forever. They’re constantly selling them to generate higher returns. Those returns take the form of capital gains distributions to you. You’ll most likely receive those gains at the end of the tax year in which the assets were sold. The gains are pro-rated, based on how many shares you own in the fund.
Under current IRS regulations, those mutual fund capital gains distributions are taxed as long-term capital gains, no matter how long the fund held the assets before their sale. This means you’ll pay the capital gains tax rate of 0%, 15%, or 20%, based on your ordinary income tax rate on those distributions.
Things are different if you sell your mutual fund shares outright. If you sell those shares before owning them for a year, the capital gains from the sale are taxed at your ordinary income rate. However, if you hold those mutual fund shares for one year or longer before selling them, you’ll pay the capital gains tax rate.
Delaware Statutory Trusts (DSTs) are also pool investments. As a DST investor, you buy fractional shares in a trust, which then pools funds to purchase real estate assets. But the DST setup is vastly different from that of a mutual fund. For one thing, DSTs are set up as pass-through entities. Any pro-rated DST rental income you might receive is taxed at your ordinary income tax rate. However, as a DST beneficiary, you could also benefit from pro-rated expenses resulting from the real estate. These expenses could be used to lower your income.
But the potential benefit of a DST is its role as a 1031 replacement property under 26 U.S. Code § 1031. Specifically, the IRS Ruling 2004-86 held that beneficial interests in a DST could be treated as replacement properties in a 1031 exchange. When conducted properly, you could defer capital gains and depreciation recapture taxes by exchanging real estate for DST shares. When the DST sponsor sells those real estate assets, you might pay capital gains taxes. Or you could roll over your share of those capital gains into another DST.
The takeaway from the above is that not all investments are created equal. This is especially true regarding mutual funds, Delaware Statutory Trusts, and capital gain taxes. To fully understand capital gains treatments on these two investment types, work with your professional – and experienced – tax advisor.