A disregarded entity is a legal structure for tax purposes under the Internal Revenue Code. It refers to a business entity that is legally separate from its owner(s) but treated as the same entity for federal income tax purposes. Common examples include single-member LLCs, which pass income or losses directly to the owner for tax reporting.
For a DST, the question of being classified as a disregarded entity is nuanced. DSTs can function as either pass-through or non-pass-through entities, depending on ownership, operation, and tax elections.
Is a DST Classified as a Disregarded Entity?
- Default Tax Treatment
- DSTs are generally recognized as separate legal entities and are not automatically considered disregarded entities. However, their tax treatment aligns closely with pass-through principles, as DST investors typically report income, expenses, and depreciation individually on their tax returns.
- Ownership and IRS Perspective
- If a DST has a single owner, the IRS could classify it as a disregarded entity for federal tax purposes, much like a single-member LLC.
- In most cases, DSTs have multiple investors, and their income is distributed proportionally among these investors. This structure disqualifies the DST from being classified as a disregarded entity because multiple owners create a separate taxpayer entity.
- Passive Investment Role
- DSTs are primarily designed for passive investment. They operate as trusts rather than actively managed businesses, keeping them distinct from typical disregarded entities in many tax contexts.
Key Features of DSTs and Their Tax Benefits
- Pass-Through Taxation
- DSTs allow income and tax benefits, such as depreciation, to pass directly to investors. Each investor reports their proportional share of the DST’s financial activity, providing tax deferral advantages without the entity itself paying taxes.
- 1031 Exchange Eligibility
- A significant benefit of a DST is its qualification for 1031 exchanges. Investors can defer capital gains taxes by selling their investment property and reinvesting in a DST, gaining a share in professionally managed properties.
- No Double Taxation
- Unlike corporations, DSTs avoid double taxation, where both the entity and the investors are taxed on income.
Situations Where DSTs Are Not Disregarded Entities
- Multiple Owners
- When a DST has multiple beneficiaries or investors, it functions as a separate legal entity, distributing income rather than consolidating it under a single tax identity.
- Separate Operations
- DSTs holding and operating large real estate assets are structured to ensure compliance with federal and state laws, reinforcing their status as distinct entities.
Final Thoughts
A Delaware Statutory Trust (DST) is generally not a disregarded entity unless it has a single owner and elects to be treated as such for tax purposes. For investment property owners, this distinction matters because it impacts how income, tax benefits, and liability are handled.
Understanding the tax implications of a DST requires careful planning and consultation with a tax professional. Whether you’re considering a DST for a 1031 exchange or as a passive investment strategy, its unique structure can provide significant benefits tailored to your financial goals.
