Investors often have questions about tax considerations related to DSTs (Delaware Statutory Trusts), including whether these trusts are pass-through entities.
Yes, Delaware Statutory Trusts are pass-through entities for federal tax purposes. This means that the income and losses of the DST are passed through to the investors, who report them on their individual tax returns.
The advantage of a pass-through entity is that the company doesn't pay taxes on the income before distributing it to the owners (beneficiaries). This structure generates a tax benefit for the shareholders since the income is only taxed once. In contrast, with a traditional corporate system, taxes are first paid at the corporate level and then again by the shareholders, who pay taxes on the dividends they receive.
As with any investment, DSTs have pros and cons. DSTs are attractive to many investors for several reasons.
First, a DST allows an investor to purchase fractional ownership of institutional-quality assets that they might not otherwise be able to own. A sponsor creates the DST, choosing and acquiring the targeted assets. Often, a DST focuses on a specific sector, such as multifamily housing, office property, industrial, retail, or niche markets like self-storage and student or senior housing.
The sponsor finances the purchases and then seeks investors, using their capital investments to replace the original financing. DSTs often have minimum investment requirements of $100,000, although some are higher and a few are lower.
Second, DSTs are convenient tools to facilitate the execution of a 1031 exchange. For many investors attempting to use a 1031 exchange to defer capital gains taxes, one challenge is identifying and purchasing replacement properties within the tight timeline the IRS allows.
Since a successful 1031 exchange requires that the total proceeds from the original asset sale be reinvested into new acquisitions, investors may have trouble finding the properties they want that fulfill the requirements and can be transacted within 180 days. DST offerings are pre-packaged, so an investor can often complete the purchase of whatever amount they need (above the minimum) in just a few days.
In addition, while the investor has fractional ownership that allows using a 1031 exchange, the trust holds the debt, and creditors cannot seek recourse from the beneficiaries.
While not necessarily a drawback, investors should be aware that DST investments require accreditation. That means that the investor must demonstrate sufficient assets to withstand potential losses. The SEC requires accreditation for risky or complex investments when the offering company is not required to disclose the same level of detail that a publicly traded stock does.
A potential disadvantage is that DST investments are illiquid. The holding period is typically five to ten years, and investors should not rely on being able to sell sooner.
Also, DSTs may have high fees that reduce the potential income. The sponsor charges fees for their management, and the trust may also pay various commissions and other expenses. The investor should assess the impact of these costs on the overall profit potential.
Finally, some investors may not be comfortable with the hands-off nature of their investment since decisions are made by the trustees, not by the owner/beneficiaries. Relinquishing direct management involvement can be either a positive or negative attribute, depending on your preferences.