Disadvantages of Delaware Statutory Trust (DST) 1031 Exchange Replacement Properties

Posted Dec 27, 2023

Image of a Delaware Statutory Trust Office property

Delaware Statutory Trusts (DSTs) are an increasingly popular investment vehicle for those seeking attractive passive investment opportunities. A sponsor creates a DST using Delaware’s unique trust regulations to design a pre-packaged offering for investors. DSTs often focus on specific real estate sectors and include assets that a typical investor could not purchase individually.

However, Delaware Statutory Trusts (DSTs) are not without their challenges, especially for investors planning on using them for 1031 exchanges. Rigorous regulations set forth by both the IRS and Congress can pose significant hurdles. Compliance with these guidelines is crucial to avoid financial and legal penalties. Therefore, investors must diligently navigate these complex rules to ensure the validity of their 1031 exchanges involving DSTs, underscoring the importance of adequate planning and expert guidance.

Why use a DST to complete a 1031 exchange?

Investors seeking to execute a 1031 exchange to defer the payment of capital gains taxes when selling an investment property may look to a DST to satisfy all or part of the required replacement investment. Because DSTs have flexible investment amounts in many cases, buying into one can successfully meet the 1031 exchange requirements for replacement value. A DST may also provide ongoing income without the need for ongoing property oversight.

What are the potential disadvantages of DST investments?

Employing DST participation to complete a 1031 exchange requires the investor to meet specific IRS guidelines. Some of the potential downside considerations include:

Investors have no control over operations. DSTs are managed by professionals, and the sponsor has the authority to make all significant decisions. That may be an added enticement for some but may frustrate other investors. DSTs have inherent risks that each investor should evaluate.

DSTs can’t raise additional capital. A DST has a specific, closed-end investment period. Once the offering is closed, the sponsor may not accept new investors or raise extra money. That means that income distribution may be disrupted if the portfolio properties need substantial capital spent on repairs or other expenses.

DST investments are illiquid. DSTs come with holding periods ranging from 5 to 10 years, and the investor cannot retrieve their capital until the DST's planned termination arrives. Investors should consider whether they may want to liquidate sooner as they evaluate a DST investment. Since DSTs lack a public market for divestiture, investors can’t count on being able to sell their shares before the planned termination. Furthermore, some offerings restrict resale, limiting the potential for an early exit.

DST investments may include high fees. Compared to direct ownership, participation in a DST may involve higher upfront and ongoing fees. A DST sponsor may charge fees for selling commissions, broker-dealer expenses, and management costs such as acquisition and disposition of property.

Does investing in a DST make sense?

DSTs offer significant potential benefits, including income, 1031 exchange eligibility, portfolio diversification, and asset appreciation. The availability of DSTs as vehicles for 1031 exchange completion can be attractive. Investors should carefully weigh the pros and cons to decide if the investment suits their circumstances.

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.

Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.

All real estate investments have the potential to lose value during the life of the investment. All financed real estate investments have the potential for foreclosure.

The income stream and depreciation schedule for any investment property may affect the property owner's income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.

Costs associated with a 1031 transaction may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.

No public market currently exists, and one may never exist. DST programs are speculative and suitable only for Accredited Investors who do not anticipate a need for liquidity or can afford to lose their entire investment.

There is no guarantee that the investment objectives of any program will be achieved.

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