Are you considering investing in a Delaware Statutory Trust (DST)? This move is an appealing option for many investors, especially because of the passive income, steady cash flow, and capital gains tax deferrals. However, it’s important that you know certain events can add risk and complexity to the investment.
In this article, Realized 1031 focuses on DST condemnation and casualty, two unfortunate possibilities that may have an impact on your tax-deferral benefits. Let’s take a closer look at how these events are treated at the DST level to help you set your expectations.
DST casualty loss occurs when a disaster (or other events) results in the loss or destruction of property. Calamities like earthquakes or fires, as well as criminal acts like vandalism, result in casualties.
Meanwhile, condemnation occurs when a government entity seizes a part of or all of the property for public use. The main principle is eminent domain, which requires the government to provide compensation for the seized assets.
In the case of either event, DSTs usually receive insurance proceeds or a condemnation award for the lost asset value. These payments result in involuntary conversions under Section 1033, and the way the funds are handled determines whether you get to maintain your tax deferral benefits or face a tax hit.
There are several ways the DST trustee or sponsor can treat the proceeds.
Section 1033 is the main source of rules for involuntary conversions.
If rebuilding or replacements are done within these windows, investors maintain their tax-deferral status. Two to three years is a long time, but challenges like zoning issues or the fact that the DST cannot have direct control over the business activities of each property can lead to delays.
If the DST rebuilds or undergoes an involuntary conversion exchange, then tax-deferral benefits remain preserved, and the only time you become liable to taxes is if the DST distributes the proceeds. As such, many sponsors choose the first two options to avoid boot.
In cases where the entire DST portfolio is affected, the sponsor may arrange a 1033 exchange into a new DST or direct property. This strategy keeps investors on a similar footing as a traditional 1031 exchange, but under the involuntary conversion framework.
When DSTs receive compensation for damaged or condemned property, the event can lead to tax liability or continued deferral depending on the next steps the sponsor takes. Rebuilding or exchanging under Section 1033 rules can preserve tax-deferral benefits, while a distribution results in boot. As such, it’s important for investors to maintain communication with the sponsor to understand what the latter is planning to do and set expectations.
Sources:
https://www.irs.gov/newsroom/involuntary-conversion-get-more-time-to-replace-property