Delaware Statutory Trusts (DSTs) And 1031 Exchange Requirements: What You Need to Know

26 U.S. Code § 1031 – known more commonly as the “1031 exchange” or “like-kind exchange,” allows investors to “swap” real estate holdings. When performed correctly, the 1031 exchange can help defer taxes on capital gains or depreciation recapture taxes. The requirement is that the relinquished and replacement properties must be used for investment or business purposes.

Furthermore, only real estate is eligible for exchange. 

However, the IRS’ Revenue Ruling 2004-86 says beneficial interests in a Delaware Statutory Trust (DST) could be considered replacement property as part of a 1031 exchange. This can benefit investors – there is the potential for diversification.

But before diving headlong into a DST 1031 exchange, it’s essential to know the following:

DST Properties are Illiquid

Investors involved with a DST as part of their like-kind exchange should understand that capital will be tied up for an extended period. How long? DSTs generally hold onto properties from three to 10 years. 

Plenty of Material Risks

DSTs mean investors have a passive interest in real estate holdings. But the underlying asset is still real estate. As such, there’s no guarantee of cash flow or appreciation. Real estate performance is highly dependent on unanticipated factors like geographic location, economic issues, and supply and demand.

Speaking of passive interest . . .

Lack of Control

The DST sponsor handles all real estate decisions, including acquisitions, dispositions, and management. Investors in the trust must understand they won’t have any say in strategic or ownership issues.

The "Seven Deadly Sins"

As part of Ruling 2004-86, the IRS lists seven key restrictions the DST trustee/sponsor must follow to ensure the trust would be eligible as a replacement property. These include:

• Once the DST’s initial offering closes, no future contributions can be accepted.
• The trustee can’t renegotiate existing loan terms or borrow new funds.
• The trustee can’t reinvest real estate proceeds from a sale.
• Reserves or cash held between distribution dates can only be invested in short-term debt obligations.
• All cash (other than necessary reserves) must be distributed regularly.
• The trustee can only make capital expenditures on normal repair and maintenance or to support non-structural capital improvements.
• The trustee can’t enter into new leases or renegotiate current ones unless there is a tenant insolvency or bankruptcy.

Any above issues could hamper the DST’s role as replacement property in a 1031 exchange.

Relinquished/Replacement Property Values

One requirement of a successful 1031 exchange is that the replacement property (in this case, the DST) is of equal or greater value than the relinquished property. If there is a gap between those values, this could lead to taxable “boot.”

The takeaway from the above is that the DST 1031 exchange can be helpful for investors who are seeking a tax-advantaged strategy. But due to the complexity, it’s always a good idea to consult with advisors familiar with the process’s ins and outs.