Delaware Statutory Trusts (DSTs) are a type of legal structure that allows investors to own a fractional interest in a legal entity that holds income-generating real estate. For those who are undergoing a 1031 exchange, investing your proceeds into a DST is a qualified strategy that lets you defer capital gains taxes.
Due to the structure and rules surrounding DSTs, this type of investment vehicle has its own advantages and disadvantages. Understanding these aspects, especially the risks and challenges you may face, is critical to help you determine whether or not DSTs are the right strategy for your investment goals.
Below, Realized 1031 has shared a guide outlining the challenges with Delaware Statutory Trusts and how you can manage these issues. Keep reading to learn more.
What You Need To Know About DSTs
To understand how Delaware Statutory Trust risks emerge, it’s important for us to provide context regarding key characteristics of this investment strategy.
- Structure: A DST doesn’t allow direct property ownership for the investors. Instead, they own shares of the DST, which in turn, owns the property. The DST sponsor handles the general operation and management of the asset.
- Holding Period: DSTs are typically structured with a holding period that’s between five to 10 years on average.
- Passive Income: Given the lack of direct control, investors earn through passive income from the activities of the property.
- Accredited Investors: Only accredited investors, as described in the criteria set by the Securities and Exchange Commission, can invest in a DST.
DST 1031 Disadvantages
The characteristics we shared above lead to several DST risks that you’ll want to keep in mind when considering this type of investment strategy.
Illiquidity
The long holding periods of DSTs make them illiquid assets. This can be beneficial for long-term investors or estate planning. However, investors who may want access to their capital within a few years will find DSTs a problematic option. Securing a secondary market for your interest may also prove difficult because DST interests are not publicly traded and their transfer is often restricted.
Lack of Direct Control Over the Property
As a DST investor, you don’t hold a title over the DST property. Instead, you own a fractional interest in the trust. The sponsor has the final say over the management and operations of the property, which means you’re dependent on the sponsor’s competence for the potential income you earn. While this lack of direct control is beneficial for those who want less involvement in their investments, DSTs may not be suitable for investors who still want to have a say over major decisions regarding the property.
Cannot Raise Capital
Another disadvantage of DSTs is that investors cannot raise money for the property. This action may be necessary for capital improvements and other substantial expenses. However, there is only one period where the sponsor is allowed to receive capital from investors, and it closes after the initial offering is complete. After that, the only source of capital improvements is the property’s operating cash flow or pre-existing reserves.
Additional Expenses
There are additional expenses in DSTs when compared to the costs associated with direct property ownership. Aside from net operating costs, DSTs will typically include fees for acquisition, management, and disposition. These costs may impact the distributed income as well as overall return on investment (ROI). Make sure to read the offerings thoroughly to avoid surprises when the time comes.
No Assurance Over the Profitability of the Property
Like most other investments, there are general risks you’ll have to consider in DSTs. There is no assurance that the property will consistently perform or provide the projected income. Economic volatility will still affect such investments. Problematic tenants, natural disasters, and new legislation are also factors that affect the profitability of the property.
Not Immune to Foreclosures
DSTs can use leverage, which means they are not immune to potential foreclosures. If the property’s income is insufficient to cover the mortgage payments, or if the loan matures and cannot be refinanced, the lender may foreclose on the property. This could lead to investors losing their capital. However, DSTs are structured to limit investor liability to their investment in the trust, protecting their personal assets.
Possible Removal of Tax-Deferred Status
For 1031 exchanges specifically, there is still a chance that the IRS may revoke your tax-deferral status in certain situations. That’s all thanks to what some refer to as the “seven deadly sins,” which are prohibitions outlined in Revenue Ruling 2004-86. If the DST violates any of the following, the service may rule unfavorably on the offering and leave you with immediate tax liability.
- No future contributions after the initial offering is closed
- No negotiation of existing loans
- No reinvestment of proceeds from the sale of the DST property into a new property
- Limited capital expenditures
- Limited investment of cash reserves
- Cash must be distributed to investors on a current basis
- No new leases or lease negotiations
These restrictions are designed to preserve the passive nature of DSTs, which is a critical factor in maintaining compliance with 1031 exchange requirements. Investors should consult with tax and legal professionals to ensure the structure of their exchange meets IRS standards.
Difficulty for Non-accredited Investors
In most cases, only accredited investors can enter a DST. Non-accredited investors may still be accepted, but there’s a limit of only 35 per DST offering. Plus, you’re required to be a sophisticated investor or have a pre-existing relationship with the sponsor to be qualified. Those who are undergoing a 1031 exchange are usually accredited investors. If you’re a non-accredited investor, you may find challenges in finding a suitable DST offering that is willing to accept you.
Wrapping Up: DST Cons to Keep in Mind
Entering a DST as part of your 1031 exchange can be a beneficial strategy for investors seeking passive real estate exposure and tax deferral benefits. However, it has inherent risks like any other investment approach. Enhancing your financial confidence comes from knowing these possible issues and following the best practices to manage these challenges.
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.irs.gov/pub/irs-drop/rr-04-86.pdf
https://www.sec.gov/resources-small-businesses/capital-raising-building-blocks/accredited-investors
https://smartasset.com/investing/delaware-statutory-trusts-dsts
