Exchanging Out of Self-Managed Rentals Into DSTs: Shifting From Active to Passive Without Breaking 1031

Owning and managing a rental property on your own can be challenging. From handling tenants to ensuring the property retains its value, there are lots of tasks and responsibilities that may lead to burnout. You may be considering letting go to ease the burden, but if the property has been acquired through a 1031 exchange, capital gains taxes will be triggered.

One solution is to exchange 1031 rentals into a Delaware Statutory Trust (DST). This investment vehicle is structured in such a way that you can let go of active management duties while still continuing the 1031 cycle. Below, Realized 1031 shares how.

The Burden of Self-Managing 1031 Rentals

At a certain point in your life, you may find active investments to be too demanding. Issues like tenant turnover, maintenance, and regulatory compliance are becoming major headaches. Aging investors, especially those who have diversified geographically, may also find directly owned assets too difficult to manage.

However, liquidating the property may not be the best solution if it’s been a part of a 1031 exchange, as this would trigger immediate tax liability. Another option is to exchange into another rental property again, but you’d end up owning another asset that needs your hands-on involvement. Fortunately, there is one other option: investing in DSTs.

How DSTs Allow the 1031 Cycle to Continue

DSTs are trust entities that own underlying income-generating properties. You enter by purchasing beneficial interests. Thanks to Revenue Ruling 2004-86, DSTs are qualified as like-kind property under 1031 exchange rules. You can use the proceeds from your previous rental property to acquire interests and begin earning monthly income. You’d continue your tax-deferral, since no official sale occurred.

Beyond preserving the 1031 exchange cycle, DSTs allow for passive investing that provides the following key benefits.

• Hands-Off Involvement: DSTs ease the burden of management since only the sponsor is allowed to manage the underlying properties, providing relief for investors.

• Professional Management: While you won’t have direct control over operations, you can rest easy knowing that the assets are under the careful oversight of experienced real estate professionals.

• Continued Exposure to the Real Estate Market: Even though you’ve opted for a passive investment, you remain exposed to the real estate market. Plus, DSTs usually own a diverse set of properties, further enhancing diversification.

Key Considerations for Investors

Exchanging out of directly owned 1031 rentals to DSTs follows the same steps as any other 1031 exchange. As such, make sure to keep the following considerations in mind.

• Exchange Timeline: The 180-day timeline and 45-day identification period still apply. Thankfully, DSTs are easier to identify and close due to their pre-packaged nature.

• Type of DST: Due diligence is critical before committing to a DST. Evaluate the properties, financials, sponsor track record, and other areas that will influence the success of the investment.

• Matching Debt: You still need to match the debt of the DST to the debt of your relinquished property. DSTs do indicate the debt in the offering memorandum, so ensure your investment is sized appropriately to avoid a taxable event.

• Liquidity Events: DSTs have defined holding periods. After that, the DST liquidates the investment. If you’re not prepared to reinvest through another 1031 exchange, you may end up with a major tax hit.

Wrapping Up: DST Rentals for the 1031 Exchange Cycle

For investors who no longer want the burden of active management while maintaining 1031 exchange benefits, DSTs are a strategic option. These passive investments allow for hands-off involvement while providing regular income through monthly distributions. Before committing to a DST, make sure to perform due diligence and consult with tax professionals to increase the chances of a successful investment.

Sources:

https://www.businessinsider.com/personal-finance/investing/1031-exchange

https://www.taxnotes.com/lr/resolve/tax-notes-today-federal/treasury-announces-ruling-on-delaware-statutory-trusts/ynnp

https://www.delawareinc.com/blog/what-is-a-delaware-statutory-trust/