For those who are interested in leveraging the 1031 exchange, joining a Delaware Statutory Trust (DST) is one popular approach you can take. This investment vehicle offers various advantages that make it easier for you to enjoy the tax exemptions of a 1031 exchange. Of course, disadvantages of DSTs exist. Understanding these risks and challenges is critical to help you make more informed investment decisions.
At Realized 1031, we’ve previously written articles about the advantages of DSTs as well as their disadvantages. In this post, we’re bringing it all together to give you a comprehensive guide in one place.
Delaware Statutory Trusts: The Basics
A DST is a legal entity or trust that owns or holds a real estate property. Investors buy shares in the trust, making them co-owners of the trust’s assets. The trust itself holds the title to the property. Thanks to this structure, investors who’d like to use the 1031 exchange can easily find an asset where they could reinvest capital gains, making it possible to defer taxes.
Delaware Statutory Trust Advantages
Thanks to how DSTs operate, investors can enjoy a few primary benefits.
1031 Exchange Eligibility
When you own “real property” the IRS allows you to defer taxes through the use of a 1031 exchange. Qualifying for a 1031 exchange requires you to have direct ownership of a property. You cannot enjoy the tax benefits if you’re investing the capital gains through a partnership or an LLC. Thankfully, the IRS treats DSTs as direct ownership of a real estate property. Hence, DSTs have become a popular investment vehicle for people who want to take advantage of the 1031 exchange.
Find a Property Within the IRS Timeframe
A 1031 exchange allows you to defer taxes if you find a suitable replacement property within 45 days of selling your original property. However, some view the 45-day time limit as short and can view it as a problem with the 1031 exchange. Next, you must complete the acquisition within the 180-day closing period. Otherwise, you pay the capital gains taxes. DSTs are easier to find, and you can easily invest — no need to wait for a closing period or other delays.
Match Property Values
When looking for a replacement property you want to find one that matches both the value and debt of the property you sold. A smaller one will leave you with taxable excess, and a bigger one requires you to pay out of pocket. One of the most significant DST advantages is how you can invest the exact amount you need so long as it follows the minimum set by the sponsor.
Protected Personal Assets Through Non-Recourse Debt
DSTs help protect investors from lenders going after their personal assets thanks to non-recourse debt — a type of loan where the lender’s only security is the property itself. If the borrower defaults on the loan, the lender can only take the property to satisfy the debt and cannot go after the investor’s other assets.
DSTs Are Pre-Packaged Investments
When you invest in a DST, the work is already done for you. The sponsor has already vetted the property and has worked with a third-party property investment company to handle everyday operations. Plus, all inspections, financial statements, rent rolls, and other matters are already taken care of.
Access to Institutional-Grade Assets
An international-grade asset is any asset large enough to attract national and international investors. Most small-time investors won’t be able to access such properties, but DSTs allow multiple investors to purchase equity in large assets. Pooling equity with other co-owners allows you to invest in properties like a $50 million apartment complex, for example.
Easier Method To Diversify Your Portfolio
One of the major advantages of Delaware Statutory Trusts is that there’s no limit to how many DST properties you can invest in. Given the relatively low barrier for entry, you can easily invest in rental property, residential homes, commercial spaces, and other real estate properties.
Delaware Statutory Trust Disadvantages
DSTs are not without challenges and risks. Here are some cons that you should keep in mind before committing to this investment vehicle.
No Control Over Operations
In most cases, the sponsor has complete control over the property. Some investors may see this as an advantage, especially if they’re the type who wants to be as hands-off as possible. However, others may want to be more involved to ensure better returns. Unfortunately, higher levels of involvement won’t be possible given the structure of DSTs.
You Cannot Raise More Capital
After the closed-end investment period, you cannot raise new money for the DST. Such a restriction can result in income distribution disruptions if the property needs capital for repairs and other substantial expenses.
High Fees
One of the most discouraging disadvantages of Delaware Statutory Trusts is the probable high operation fees. These fees include commissions, broker-dealer expenses, and management costs. Plus, the upfront and ongoing fees will lower your expected income.
Illiquid Asset
DST investments typically have a holding period of 5 to 10 years. You won’t be able to liquidate your capital until the date of the planned termination arrives. As such, you’d have to consider whether you want this capital to stay frozen or if you have other plans that require you to liquidate sooner. Resale is also not an option in most contracts, so early exit is not possible.
Final Thoughts: Advantages and Disadvantages of a DST
When looking for ways to qualify for 1031 exchange tax benefits, Delaware Statutory Trusts are becoming an increasingly popular option. This investment vehicle has several benefits that make it easier to invest capital well within the IRS deadlines and requirements. Still, DSTs are not without disadvantages, such as lack of control over the asset and long holding periods. So before you commit to this type of investment, always make sure to weigh the pros and cons to make the right decisions. Use the guide we shared or contact us to learn more.
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.
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