Commercial real estate investment has become one of the latest asset classes to help investors further diversify their portfolios along with historical choices such as bonds and equities. There is a potential for good returns, and you can diversify your portfolio for added security. The main drawback of commercial real estate is that it can be hard to penetrate. Investing in these properties takes a lot of initial capital. There’s also the matter of management, an intensive process that eats up effort, time, and funding.
So, how can small-time investors reap the potential rewards of industrial-grade real estate? Delaware Statutory Trusts (or DSTs) are one way to do so. These legal entities are one way for investors to take advantage of the benefits of 1031 Exchanges. Through DSTs, even investors with limited capital can still tap into an institutional-quality asset.
What is a DST exactly? How does it work? What are the pros and cons that every investor must take into consideration? At Realized 1031, we’re sharing our most comprehensive DST guide to help answer all your questions.
What Is a Delaware Statutory Trust (DST)?
A DST is a legal entity that owns or holds a real estate property. The real estate ownership structure includes multiple investors who hold undivided fractional interest in the trust. If the property earns and appreciates, the investors grow their capital. However, they have little to no control over the commercial property itself. It’s the professional real estate company, or the DST sponsor, who oversees management and operations. It’s also the one that identifies and acquires the real estate asset.
The capital gets offset as soon as individuals start investing their money into the DST. Over time, the investments replace the sponsor’s initial capital. At this point, the investors wholly own the DST. The sponsor will still operate and manage it, but they don’t have any stake in aspects like property appreciation.
Like in most trusts, investors hold a beneficial interest in a DST. They have the right to receive benefits from the assets, but no one can claim single ownership. Every investor holds a percentage instead.
History of DSTs
DSTs are not an investment vehicle exclusive to Delaware as the name may suggest. However, it does offer us insights into the origin of this investment vehicle. The state has many wealthy families that depend on common law trusts to ensure easy transfer of generational wealth. However, things were more ambiguous when it came to business trust.
In 1986, the Delaware General Assembly initiated an overhaul of the state’s trust laws. The state then passed the Delaware Business Trust Act in 1988. In 2002, this law became known as the Delaware Statutory Trust Act. It allowed the state to define and legally secure trusts.
Over the years, the Delaware Statutory Trust Act continued to advance. Investors saw how the trust beneficiaries have no real direct ownership of a property. Instead, an individual owned shares of the DST. As such, the investors’ personal assets are protected even when the DST goes into debt. This framework became even more attractive once the IRS Revenue Ruling 2004-86 clarified DSTs’ eligibility for 1013 Exchanges.
For a more in-depth history of Delaware Statutory Trusts, read another article here.
Importance of DSTs in the Real Estate Investment Industry
DSTs provide a gateway for investors to institutional-grade investments. This investment vehicle enables investors to participate in large-scale real estate projects that would otherwise be inaccessible due to high capital requirements. Additionally, DSTs offer a true passive investment experience. Professional managers, supervised by the sponsors, handle the day-to-day operations and maintenance of the properties.
The other important benefit of DSTs is how they enable investors to enjoy tax benefits from 1031 Exchanges. Also called a “like-kind” exchange, 1031 Exchanges allow property owners to defer capital gains taxes after selling a property. The owner reinvests the profits into a similar property, delaying the need to pay taxes indefinitely. However, there are a few requirements and strict deadlines that make it hard for an individual to find suitable properties.
How Do DSTs Work? Legal Structure and Framework
For investors, DSTs have a less complicated structure and faster closing process than some of the other real estate options. However, there is a lot more going on behind the scenes. In this section, we’ll discuss in-depth what goes on behind the trust.
DST Companies or Sponsors
We’ve mentioned how investors own the shares of the DST and not the real estate property itself. That’s because the trust itself is the “owner” of the title. A DST company or sponsor serves as the main “trustee” in such an arrangement. The sponsor oversees everything, from finding suitable properties to hiring property managers who will oversee the day-to-day operations of the commercial property.
Finding and Acquiring Properties
The sponsor is responsible for finding possible options, analyzing several real estate properties to select the best. With its own capital, the company purchases the property and begins offering it to qualified investors.
Assigning a Master Tenant
DST rules mandate that trustees cannot enter new leases or negotiate existing contracts. As such, the sponsor will arrange for a subsidiary to serve as the “master tenant.” This entity leases the entire property and handles other operational responsibilities. The DST has thus essentially separated itself from lease negotiations, enabling investors to enter or exit via 1031 Exchanges.
Marketing to Broker-Dealers
Sponsors will need to market their DST offerings to broker-dealers. These firms serve as the middlemen between investors and DST sponsors. Broker-dealers vet the DSTs and determine if they want to offer these investment opportunities to their clients, the investors.
Fractional Ownership
As we mentioned above, investors or beneficiaries hold fractional interests in the trust, purchasing these shares from the sponsor’s offerings. These sales displace the DST company’s ownership until the entire DST is owned by the investors. No single investor can claim sole ownership rights to the trust, even if one investor invested a considerably larger amount than others. Plus, the investors have no say in how the real estate property operates or how it performs. After all, it’s the trust they own, not the commercial building. The investors have completely passive roles.
Restrictions
Given how the sponsor handles all the complexities in a DST trust, investors can remove themselves from the burden of active property management. You won’t need to handle any processes, requirements, and other administrative burdens such as trust management and performance analysis. Even with such freedoms, the IRS strictly regulates DST as 1031 Exchange-qualifying entities. There are the so-called seven deadly sins in DSTs that all investors must be aware of even if they play a passive role. These aren’t sins per se but restrictions that investors and sponsors must follow to maintain the tax-deferred status and compliance with IRS guidelines.
- No Additional Capital: Sponsors can only accept investors within a given period of time. After the DST is closed, investors cannot make capital contributions. Sponsors are also not allowed to accept new beneficiaries.
- Loan Terms Cannot Be Renegotiated: Trustees are not permitted to renegotiate existing loan terms. The only exception to this rule is if a tenant within the trust’s properties goes bankrupt or becomes insolvent, resulting in a default on the loan.
- Trustees Can’t Reinvest DST Profits: Sponsors cannot reinvest proceeds after the DST reaches the end of its cycle. All the proceeds must be given back to the investors.
- Trustees Can Only Spend Capital on Standard Repairs: The main effect of this restriction is that DSTs cannot own speculative development property, only ones that currently exist. Plus, the DST can’t own and operate businesses directly. The sponsor is limited to maintaining and managing the properties without engaging in significant improvements or business operations that would alter the nature of the investment.
- Cash Reserves Can Only Be Reinvested in Short-Term Debt: If a DST is holding cash that cannot be distributed to investors yet, the trustee can only reinvest the cash as a short-term debt obligation. This restriction keeps the liquid cash safe before the DST can distribute it.
- Cash Distribution Must Be on a Regular Basis: Trustees must distribute all cash, other than necessary reserves, on a regular basis. The frequency depends on the specific terms, but the common ones are monthly and quarterly.
- Trustees Cannot Renegotiate DST Leases: This restriction incentivizes sponsors to look for long-term leases.
Expected Fees in DSTs
DSTs are not without administrative and underwriting costs. These initial expenses usually occur during the property acquisition stage and when structuring the trust. The sponsor will initially pay for these fees, and the investors will pay them once they accept the offering or invest in the DST. Some specific expenses are the following.
- Due diligence fees during property search and acquisition
- Costs associated with obtaining financing for the property, such as loan origination fees and interest reserves
- Tax attorney services for a tax opinion letter, which confirms that the trust qualifies for a 1031 Exchange
- Commission fees for marketing and broker-dealer services
- Initial payment for setting up property management services
- Closing costs for purchasing the property, such as escrow fees and title insurance.
After the initial costs, there are a few recurring expenses that investors must keep in mind to manage expectations when it comes to profits. The most obvious ones are the ongoing operational costs, property taxes, and repairs. Of course, investors won’t need to handle the payments, but the source of funds will be the income generated by the property.
One other major ongoing expense is the payment for the DST sponsors. The IRS does not allow these entities to participate in any potential appreciation of the DST’s real estate once it’s sold in the future. As a workaround, the sponsor earns by getting a percentage of the property’s income on a current basis. This condition means an additional deduction on the investors’ end.
Finding Suitable DST Properties
Most sponsors for DSTs are national-level real estate firms and typically have the resources to find and acquire commercial properties, with enough initial capital for all the expenses required. These DST companies will also usually work with other parties or companies to perform due diligence and create the structure. After every process has been accounted for, the company creates a packaged DST that it then markets to broker-dealers. These middlemen have all the necessary licenses to facilitate the transaction between a DST company and the investors.
A single DST company can usually own multiple properties, but these are a single property type. For example, DST “A” can own several condominiums, but it typically won’t branch out to townhouses or single-family homes. As we mentioned above, the properties are typically institutional grade. DST companies won’t get much profit from smaller commercial properties.
One challenge is that even though a lot of newer commercial real estate properties are managed under DSTs, investors won’t be able to find one available to the public. There are certain regulations by the Securities and Exchange Commission (SEC) that prevent sponsors from marketing directly to the public. For example, rule 506(b) of Regulation D requires sponsors to market to accredited investors only, defined by their income and net worth. If you are looking for DST offerings, you will need to find broker-dealers or 1031 Exchange advisors. These are the entities DST companies work with to make their offerings available to the public.
At Realized 1031, one of our specialties is helping you find DST replacement properties for a 1031 Exchange. We work with some of the country’s top sponsors to help you access the DST that suits your needs.
The DST 1031 Exchange Process: Steps To Follow
A successful 1031 Exchange to a DST trust involves planning and research on your end with the help of a 1031 Exchange expert. These steps do not just apply to those new to the game. As you become a more experienced investor, you’ll gain a deeper understanding of the critical role of working with advisors. With the help of these professionals, you can ensure compliance, understand your tax liabilities, and find suitable DSTs that suit your goals.
After consulting with a 1031 Exchange advisor about your goals, here are the next steps you should take.
1. Get an Estimate of Capital Gains Tax
The general first step is to calculate how much you might pay in capital gain taxes on the property you are planning to sell. Knowing this value helps you determine if you qualify for any tax exemptions. Federal and state regulations have their own thresholds, which you must take into account to determine if the leftover taxable income from your capital gains is enough to qualify for the minimums set by DST companies.
In general, the minimum investment amount is $100,000 for 1031 Exchanges. So, if your total capital gains are $550,000 and $500,000 is tax-exempt, then the remaining $50,000 may not be enough. There are cases when DSTs lower the minimum to $25,000 if you’re paying with cash. Working with a broker-dealer or 1031 Exchange advisors can help you find these DSTs.
2. Get To Know the Rules of 1031 Exchanges
The IRS has strict timelines and rules when it comes to processes like a 1031 Exchange. Understanding these restrictions helps ensure that investors remain qualified for the tax deferral. There are another seven rules distinct from the seven deadly sins. These are the following.
- When To Set Up the Exchange: The IRS requires that investors set up the exchange before the sale. You must find and engage with a qualified intermediary (QI) who will facilitate the transaction even before you sell your original property.
- “Like-kind” Property: As the alternate name for 1031 Exchanges suggests, you must find a property that is in the same asset class as the one you’re going to relinquish. The IRS is pretty flexible in what the replacement property will be so long as it will be used for investment. For example, the property you’re going to sell can be an apartment while the property you’re going to buy is raw land that will later be developed for commercial purposes. However, you cannot exchange proceeds from an apartment building for a residential, single-family home.
- Same Taxpayer: The taxpayer relinquishing a property must be the same as the one acquiring the replacement property.
- Equal or Greater Value: You’ll need to find a property that has equal or greater value than the one you’re relinquishing. IRS requires that you use all the net profits from the home sale — equity and capital gains included — to gain full tax deferral. You can choose not to, but the leftover amount will be considered as “boot” and will be subject to capital gains tax.
- Boot: Boot is a catch-all term for all additional value from the exchange outside of the like-kind property. Aside from the value you choose not to invest, boot can include cash from the sale or a reduction in mortgage debt. These are all taxable.
- 45-Day Identification Period: In a 1031 Exchange timeline, the IRS gives you only 45 days to find potential properties to acquire. You’ll need to work with your QI and unambiguously describe the chosen properties through their address or legal description within this period.
- 180-Day Exchange Period: As a whole, the 1031 Exchange timeline consists of a 180-day purchase period. This includes the 45-day identification period. The other 135 days are for closing the new purchase.
3. Defining Your Financial and Lifestyle Goals
The next step after learning about the rules of a 1031 Exchange is setting your financial and lifestyle objectives. As an investor, you should have a clear idea of what you want to accomplish today and in the future. This step removes any room for ambiguity, helping you find the possible replacement properties that are more suited to your needs. Some specific aspects you need to think about are your risk tolerance, liquidity, desire for management control, and appreciation goals.
4. Finding and Evaluating Your 1031 Exchange Options
Identifying possible replacement properties is a challenging process, with lots of factors you need to consider. It’s practical to do this step before relinquishing the property you want to sell. Thankfully, you can make this easier when you choose to work with a DST instead of just searching for individual replacement properties on your own. Working with companies like Realized 1031 gives you access to pre-packaged DST offerings that help streamline the exchange process. With our guidance, there’s a higher chance of finding a property that fits your investment goals.
5. Selling Your Property
When you have a selection of possible replacement properties, you can begin the process of selling your current real estate property. Find a real estate agent or broker who can help with various aspects of this process, such as market research, buyer negotiations, and closing contracts.
6. Find a Qualified Intermediary
The QI, also called the 1031 Exchange Accommodator, plays an important role in the exchange process. This third party has various responsibilities to help ensure that the entire transaction remains compliant with IRS rules. As such, it’s critical for investors to engage with the right QI to ensure a successful exchange. The three primary responsibilities of the QI are as follows:
- The QI holds the proceeds from the relinquished property sale in escrow. This step is necessary since the exchanger cannot hold the money.
- The exchange accommodator is also responsible for completing all documentation related to the investor’s identification of the replacement property within the 45-day period.
- Once you’ve selected the replacement property, the QI is responsible for releasing the proceeds to the property seller or title company. In DSTs, this party would be the sponsor.
7. 45-Day Identification Period
Once you’ve closed the sale of the relinquished property, the 45-day identification period begins. This follows calendar days, not business days. Once the period elapses, you must notify your QI about the identified replacement property. While you do not need to acquire the property just yet after 45 days have passed, you cannot add new properties to the identification documents.
In a traditional 1031 Exchange, it may be harder to find a replacement property that closely matches the value of your relinquished asset. DSTs can potentially eliminate this issue altogether. If you select this approach, you should already be working with a DST broker-dealer by this point to secure your investment.
8. Close Before the 180-day Rule Elapses
The final step for the 1031 Exchange is closing the sale. You must do so before the 180-day rule by the IRS elapses. Failure to meet this deadline will result in the disqualification of the exchange, and the transaction will be subject to capital gains taxes. Thankfully, DST 1031 Exchanges are pretty straightforward. Given the pre-packaged nature of DSTs, the complexities of buying and starting the operation of a commercial property will no longer be the investor’s problems. In some cases, the closing period can be as short as one to two weeks.
DST Due Diligence: Things To Consider When Choosing Your Next Investment
On paper, DSTs seem like a plug-and-play investment that won’t take much effort to get into. This idea has some truth, with many investors viewing DSTs as easy ways to enjoy 1031 Exchange benefits. However, the popularity of this investment vehicle has led to many new DST companies that want their slice of the cake. Some are inexperienced and others have downright nefarious objectives. As such, due diligence on the company they work with is important for investors. This practice helps you avoid unnecessary risk and increase your chances of getting good returns.
1. Vetting the DST Sponsor
The first aspect investors must evaluate is the sponsor. Who are they? And what does their track record look like? Having the answers to these questions helps you understand the sponsor’s experience and overall capabilities. You’ll need to determine if the sponsor specializes in certain types of properties and if these match your investment needs. It’s also a good idea to check how the sponsor manages the properties at each stage of the real estate cycle.
There are two main places to evaluate possible sponsors. First, you can check the reviews on the internet. The other option is to look at the offerings, which often include details about the sponsor’s previous performance. As a reminder, a good performance in the past doesn’t automatically guarantee the same for the next one. Make sure to temper your expectations.
2. Assessing the Projected Returns
Offerings always include projected returns to help investors get an idea of what they can earn. These numbers often come from assumptions about the property’s potential performance, including rent growth and occupancy rates. However, the forecast may not always be accurate. The calculations can even be overstated to attract more investors. You can do your own research by checking market reports and appraisals. The information is useful in determining whether the financial projections are realistic.
3. Fees
Another aspect you should look carefully into is the fees. Unreasonable ones could lead to little profits on your end as the investor. Make sure to assess the details of each fee, like how much will be dedicated to the acquisition, management, and other areas. We also suggest checking the fees of other sponsors and comparing them to the ones you want to work with. This practice will help you gain a better idea of the average for each area and determine if your choice DST company is offering reasonable fees.
4. Exit Strategy
One of the major challenges in a DST investment is illiquidity. You can’t sell or exit the contract whenever you choose, thanks to the holding period. Most DSTs have a holding period of between 5 to 10 years. Hence, it’s important to understand when the sponsor plans to sell the property and return your capital. You should also check if there are special provisions in the contract for early exits. With this information, you can better make a timeline for your financial plans and investment horizon.
What Happens at the End of a DST’s Lifecycle?
The entirety of a DST’s life is called a full-cycle event. This begins from the time the sponsor acquires the commercial real estate property and ends once the property is sold and the sponsor redistributes the proceeds to the investors. As we mentioned, it’s important to consider what happens once a DST finishes a full-cycle event. Having a solid plan helps you take the next steps with your capital. For most investors, these are the three popular options.
Join Another DST
This practice is how you can continue the tax deferral benefits of the 1031 Exchange. You can reinvest the proceeds indefinitely, helping you defer capital gains taxes and continuing the stream of passive income. You should still conduct a thorough assessment of sponsors and the properties to ensure that your next investment still aligns with your goals.
Reinvest in Direct Property
During the DST cycle, some investors may realize that they prefer having more control over the daily operations of the property. After the DST ends, these individuals may choose to reinvest the proceeds directly into a commercial real estate property. That way, the investors can play a more active role. If you choose this path, you can still enjoy the 1031 Exchange tax deferral so long as you fulfill the requirements and deadlines set by the IRS. Those who opt for direct real estate property must consider their experience, expertise, and willingness to handle more responsibility before committing to this route.
Cash Out
The third option is to cash out your proceeds and use it for other purposes. This liquidity gives you more freedom, especially if you want to spend the money for personal reasons. Those who’d like to diversify outside of real estate can also use this option. One thing you have to consider is that once you cash out, the tax deferral stops. You will need to pay capital gains taxes. We advise you to work with a tax professional to gain a clearer understanding of the tax implications involved in cashing out.
721 UPREIT
An UPREIT or 721 Exchange is an investment vehicle that lets you exchange your real estate property for units in an operating partnership (OP). This exchange is just one of the many ways that investors use to defer capital gains taxes. Other popular ones include 1031 Exchanges and deferred sales trusts.
There also might be other less common options and we recommend you work closely with your own tax and financial advisors.
Pros and Cons of DST Investments
Even though DSTs have become a popular investment vehicle, they are not without inherent risks and challenges. Understanding both the advantages and disadvantages can help you make more informed decisions before you fully commit to this investment vehicle. Here are some of the most important considerations.
Pros
- Pre-packaged Investment: The biggest drawback of 1031 Exchanges is the difficulty of finding like-kind properties within the given timeframes. DSTs remove this issue by being a pre-packaged investment. You won’t need to spend time searching for individual properties as the DST sponsor handles the acquisition and management.
- No Need To Match Property Values: Another strict IRS requirement for 1031 Exchanges is that the replacement property must be of similar or greater value than the relinquished property. DSTs resolve this issue and even allow small-time investors to tap into institutional-grade assets.
- Protected Personal Assets: Given how DSTs include non-recourse debt, investors can protect their personal assets in case the property underperforms or fails. The lender can only pursue the property instead of the DST owners.
- Easy Method To Diversify Your Portfolio: Joining a DST allows you to invest in as many properties as you can so long as they fit the “like-kind” requirement. With the relatively low investment minimum, you may find it easier to invest in commercial real estate, rental property, and other similar assets.
Cons
- Lack of Direct Involvement: This challenge may be an advantage to investors who prefer more passive roles. However, some individuals may be more comfortable with investments that allow some level of control over operations and management.
- High Fees: DSTs tend to have high operational fees, which may diminish investors’ returns. This issue is to be expected given how various parties, including the sponsor, property managers, and intermediaries, are involved in managing and maintaining the property.
- Illiquid Asset: While most DSTs seldom have holding periods that last more than 10 years, there are ones that reach up to 12 years. Within these timeframes, your investment remains illiquid. You will need to find other sources if you need funds on short notice.
We’ve shared more comprehensive posts about the advantages and disadvantages of DSTs. Check out our articles to learn more.
Wrapping Up: DST for Smarter Real Estate Investing
Having a clear and in-depth understanding of DSTs is one requirement before you try this route. With knowledge in areas like due diligence, the 1031 Exchange process, and the rules and timelines set by the IRS, you can navigate the complex processes and be one step closer to enjoying the tax benefits. Follow our comprehensive guide as you begin your journey or if you’re a DST veteran who needs a refresher.
If you want to find out if DSTs are the ideal option for your real estate investment needs, contact us. The Realized 1031 team has experienced members who provide guidance and other services related to DSTs and 1031 Exchanges. Schedule a consultation with us.
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.
Sources:
https://www.investopedia.com/terms/b/beneficial-interest.asp
https://law.justia.com/codes/delaware/title-12/chapter-38/subchapter-i/section-3801/
https://www.irs.gov/irb/2004-33_IRB#RR-2004-86
https://delcode.delaware.gov/title12/c038/sc01/
https://www.sec.gov/resources-small-businesses/exempt-offerings/private-placements-rule-506b
https://www.re-transition.com/investing-delaware-statutory-trust/
https://blog.fgg1031.com/blog/a-closer-look-at-the-seven-deadly-sins
