Ground-Lease DSTs vs. Fee-Simple DSTs Inside a 1031: Structural Differences That Matter

As you enter a Delaware Statutory Trust (DST) for the passive income and tax-deferral benefits, you acquire a beneficial interest under a fractional ownership framework. What about the DST? How does it own the underlying properties?

There are a few types, but two emerge that warrant closer examination: ground-lease DSTs and simple-lease DSTs. Understanding the structural difference of each one is critical for investors, as they have different impacts on risk, return, and long-term investment strategy. Below, we share a breakdown of each structure to help you gain a clearer picture.

Fee-Simple Interest Features

Fee simple ownership, sometimes called a simple lease, is the most complete form of ownership. In this case, the DST owns both the real estate asset and the land on which it stands. The free-simple interest allows the DST to own the entire property outright, and only governmental power, like eminent domain and taxation, can affect ownership.

This structure leads to benefits like the following:

• Maximum control of the asset (to the extent that DSTs are allowed per Revenue Ruling 2004-85)
• Longevity in ownership, since there is no expiration of the lease
• Eligibility for depreciation

However, these leases often have a higher entry cost, and the DST is also exposed to all property risks.

Ground-Lease Characteristics

In a ground lease model, the DST owns only the leasehold interest in the property’s improvements (the building), while a separate entity (the ground lessor) retains the fee-simple interest in the land.

Ground leases typically have terms that last from 50 to 99 years. Once this lease is over, the ownership of the structure returns from the DST to the ground lessor. This stage is called the reversion.

This structure leads to benefits like the following:

• Lower barriers to entry than simple lease structures, which may result in a high cash-on-cash return
• Reduced land-related expenses
• The DST can focus purely on the performance and management of the building

There are a few disadvantages to the ground-lease structure. Reversion risk is always on the horizon, so the investment’s lifespan is tied to the remaining term of the ground lease. Ground rent can also increase, affecting cash flow.

Why Structure Matters in 1031 Exchanges

There are a few ways either structure impacts the 1031 DST investment.

• Exchange Eligibility: Both ground lease and fee-simple DSTs are generally eligible for 1031 exchanges, as long as the leasehold interest exceeds 30 years (including renewal options). However, a ground lease with a term under 30 years is not eligible.

• Depreciation: A fee-simple lease allows you to freely depreciate both the building and a portion of the land value. Meanwhile, a ground lease has more limitations, given that the DST cannot depreciate the land.

• Cash Flow and Value: The lower acquisition costs from a ground lease can result in higher cash flow. Simple lease structures, meanwhile, offer investors greater certainty and stability in the income stream, which can lead to a higher overall property valuation.

Comparing Ownership Structures in DSTs

Scrutinizing the lease terms of property ownership in DSTs is a crucial part of due diligence. Ground-lease and simple-fee DSTs have their unique set of advantages and disadvantages, and knowing these differences can help you prepare for reversion risk or understand the impact of the remaining lease term on your equity’s terminal value.

Sources:

https://www.taxnotes.com/research/federal/irs-private-rulings/letter-rulings-technical-advice/exchange-of-properties-and-leasehold-interests-qualifies-as-like-kind/1gbnd

https://www.investopedia.com/terms/g/ground-lease.asp

https://www.rocketmortgage.com/learn/fee-simple