When you choose to invest in Delaware Statutory Trusts (DSTs) for tax deferral or passive income benefits, your attention is usually entirely on the tax benefits and profitability. However, the finer details (like reserves and return of capital) also deserve your close inspection, because these can affect your DST adjusted basis and, by extension, long-term tax outcomes.
In this post, Realized 1031 shares what you need to know about these concepts in order to make well-informed investment decisions.
As part of their responsibilities, DST sponsors maintain reserve funds to cover unexpected repairs, maintenance, and other operational needs. This amount is taken from the income of the properties and isn’t distributed, at first, to the interest holders or investors. While this lowers income, having reserves helps ensure steady cash flow for the long term since there are funds for contingencies.
The return of capital is the redistribution of your original investment, which isn’t considered taxable since the amount doesn’t include the appreciation from the DST properties. In essence, the DST is giving back part of the money you invested rather than paying you taxable earnings. This redistribution generally happens when the income generated by the DST property is less than the distribution amount paid to investors.
The adjusted basis in real estate investments, including DSTs, is the value of the original investment plus or minus adjustments made over time. Certain factors, like the return of capital and DST reserves distributed at the end of the holding period, cause the basis to change or adjust. Understanding how various factors affect the basis helps you better calculate the gain and the tax that comes after.
The reserve and return of capital affect the basis in a few ways. Here’s how these two factors interact with the value of your investment.
As return on capital and reserves change the DST adjusted basis, they affect the future taxes you’ll need to pay. This is especially significant for those who entered the DST through a 1031 exchange. For example, as return on capital lowers the basis, you could end up with a bigger gain later, resulting in higher capital gains taxes.
In terms of income, the presence of the reserve does reduce the total income you receive monthly. However, the benefit is that the distributions tend to be less volatile since there is a cushion against unexpected expenses.
Overall, being aware of basis adjustments helps you plan for eventual liquidation, reinvestment, or estate planning.
While DST reserves and return on capital may seem like minor financial details, they have an effect on your investment and affect your income and future tax liability. Knowing how each one affects the basis helps you keep track of these accounting figures and better prepare for what they bring.
Sources:
https://www.law.cornell.edu/wex/adjusted_basis