Real estate investors who need to complete 1031 exchanges may choose to invest sales proceeds from their relinquished properties into Delaware Statutory Trusts (DSTs).
DST investors purchase fractional shares in the trust, which holds commercial real estate (CRE) that’s sourced, acquired and managed by the DST’s Sponsor. Although exchange investors can reap the tax benefits associated with 1031 exchanges, as well as potentially enjoy additional benefits associated with direct property ownership, they don’t actually own any equity in the trust’s underlying assets – the DST holds title to all real property held under trust.
Let’s take a closer look at how the Delaware Statutory Trust ownership structure works.
DST Property Ownership Structure Provides Liability Protection for Investors
Delaware Statutory Trusts are rather unique real estate investment vehicles. DST Sponsors are typically professional real estate companies who lean on their experience – and capital – to source and acquire the commercial properties that are placed under trust. Sponsors typically focus on one sector of CRE, such as multifamily, self-storage, office, or student housing, for example. DST properties also usually have valuations in the tens of millions, or more, which places them out of reach of many solo investors.
Once a Sponsor acquires a property to be held under trust, it opens an offering period for accredited investors until the Sponsor’s equity investment has been replaced with investor capital and the offering period ends. As noted, DST beneficiaries own shares of the trust rather than equity in the underlying properties. This distinction is important because it provides legal separation for DST beneficiaries from the assets held under trust.
Let’s unpack that a bit further. DSTs are viewed as independent legal entities created under provisions set forth by the Delaware Statutory Trust Act. Creditors, or other beneficial owners of the trust, do not have any right to exercise legal remedies against the properties held by the trust. Similarly, trust beneficiaries hold no specific interests in statutory trust property. The structure of separating ownership of trust assets from trust beneficiaries can be important to many investors because it’s a way to potentially manage personal liability and asset risk.
Direct property ownership does not offer this same level of legal separation. Investors who hold title to real estate also must consider a range of factors that can heavily influence asset performance and potential returns, such as equity capital, debt financing, negative leverage, illiquidity, asset management, maintenance and repairs, and personal time. Passive ownership investment vehicles, such as DST, can remove or mitigate many of these potential risk factors from the equation.
DST investors also can gain exposure to different asset classes of commercial real estate in varying geographical locations without having to be actual property owners. It can be a way to gain exposure to the potential benefits of real estate, enhance portfolio diversification, and attempt to manage concentration risk. DSTs also have the potential to generate income from monthly rental payments and provide beneficiaries with a passive income stream.
DST investors also can 1031 exchange into and out of Delaware Statutory Trusts, which provides increased investment flexibility and the opportunity to defer capital gains taxes on the sale of appreciated real estate.
Closing Thoughts
Think of DST Sponsors as dealmakers who source, acquire, finance, and pre-package DST offerings. That heavy upfront lift simplifies the process of investing in a Delaware Statutory Trust – property due diligence, financial modeling, appraisals, securing financing, and other important considerations are handled by the DST Sponsor.
Beneficiaries, meanwhile, purchase fractional interests in the DST until the Sponsor’s capital is displaced. Investors own a percentage of the trust according to their pro-rata investment in the DST, but the Sponsor retains full ownership of all assets acquired and placed under trust. This passive investment model separates investors from any potential debt or liabilities incurred by trust assets.
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.
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.
