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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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:
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
We’ve shared more comprehensive posts about the advantages and disadvantages of DSTs. Check out our articles to learn more.
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