As an investor, your usual primary focus when investing in Delaware Statutory Trusts (DSTs) is the cash flow and tax-deferral benefits. However, there is one other aspect worth your scrutiny: the exit strategy. How and when you transition from the DST is crucial to your investment planning, especially if you’re entering through a 1031 Exchange.
The exit strategy is predetermined by the sponsor, so you should have an idea even before you enter one. There are three common avenues: a refinance, a sale, or an UPREIT conversion. Realized 1031 discusses each option in-depth to help you understand the framework and how each one fits your overall investment strategy. Keep reading to learn more.
A DST refinancing is a rare event that violates one of the seven deadly sins outlined by Revenue Ruling 2004-86. In particular, DSTs eligible for 1031 Exchanges aren’t allowed to renegotiate debt terms, as this constitutes “active” management. However, there is one specific circumstance where refinancing is the only exit strategy available: the loan matures, but the debt remains unpaid.
Sponsors typically align the end of the DST’s holding period with the loan maturity date. However, there are cases when the underlying properties fail to perform and provide enough income to cover debt services. Refinancing becomes necessary in this case, but the DST will need to convert into a springing LLC to be able to make this process possible.
In such an event, the DST loses its 1031 Exchange eligibility. You will be liable for all the previous tax-deferred capital gains, but you’ll still be able to save your investment thanks to this mechanism. Still, a refinancing is not the ideal scenario. Under normal circumstances, either a sale or an UPREIT contribution is the preferred choice.
The most standard DST exit strategy is the property sale or disposition. Once the holding period is over, the sponsor begins listing the assets, negotiating with buyers, and closing sales. The income from these sales, along with the rest of the cash reserves and your initial investment, will be distributed back to you.
On your end, as an investor, you can go with either of these two options.
The other route sponsors take is contributing the underlying properties to an umbrella partnership real estate investment trust (UPREIT). An UPREIT is another trust vehicle that owns underlying income-generating properties. However, instead of beneficial interests, investors own operating partnership (OP) units that are the economic equivalent of REIT shares. You earn dividends based on the OP units you own.
This contribution is called the 721 Exchange, and it’s also tax-deferred. As such, UPREITs are suitable avenues for investors who no longer want to continue the 1031 Exchange cycle but would like to have more control over capital gains tax payments. That’s because converting OP units to REIT shares is a taxable event. However, you have full control of how many units you convert, helping you manage tax payments.
UPREITs and DSTs have similar enough structures, so exiting a DST into an UPREIT won’t make as much of a difference for investors. You still enjoy benefits like the following.
Refinancing, property sale, and UPREIT contributions are the three primary ways of exiting a DST. Each one is more applicable than the other under unique circumstances, but the latter two are the most conventional and preferred options. Understanding how each strategy affects your overall investment plans is crucial to ensure continuity and avoid unplanned tax hits. As such, reviewing the exit strategy of the DST offerings becomes a critical step to determine if the investment aligns with your long-term wealth preservation goals.
https://www.investopedia.com/terms/u/upreit.asp
https://www.investopedia.com/financial-edge/0110/10-things-to-know-about-1031-exchanges.aspx
https://mf.freddiemac.com/docs/multifamily_legal_fyi_delaware_statutory_trust_august_2014.pdf