At the end of a Delaware Statutory Trust (DST), the DST sponsor sells the assets and distributes the proceeds to the holders of beneficial interests. If you’re an investor, it’s crucial to know the difference between the original capital and gain from appreciation because of the different tax treatment and reporting requirements. Having this knowledge helps you prepare for your tax obligations and streamline your exit strategy after the full cycle event.
In this article, Realized 1031 shares how each aspect of the proceeds is treated. Keep reading to learn more.
Return of Capital
The capital returned to you after the DST liquidity event is your original investment. Now that the investment is over, the original principal returns to the investor, per IRS rules.
Let’s create an example.
- In 2015, you acquired DST interests by investing $500,000 in the DST.
- The DST reached the end of the holding period in 2025 and sold all its underlying properties.
- The sponsor distributes $600,000 to you. In this case, the $500,000 is your returned capital.
On the tax form, the capital won’t be reported as income since it was originally yours. Instead, it reduces your cost basis in the investment.
Keep in mind that return of capital can also occur during the term of the DST, not just at the end. This usually happens when the DST is earning less than the promised distribution amount. However, the same benefit of lowered basis also applies in such a scenario.
DST Capital Gains at Exit
The other portion of the proceeds is the capital gains you made from the underlying properties’ appreciation, as well as the appreciation of your own DST interests. If the assets are sold at a higher value than your adjusted basis, then the realized profit is considered the gain.
In our example, the $100,000 leftover from the $600,000 proceeds is considered the capital gains. This time, the income is taxable and follows capital gains tax rates. You might need to pay up to 20% of the gains if you’re in the highest bracket. Depreciation recapture applies, too. This aspect follows the often higher ordinary income rates.
To avoid the tax hit, many investors choose to continue tax deferral through another 1031 exchange. Umbrella partnership real estate investment trust (UPREIT) rollovers can also be an appealing option.
How These Figures Appear on Your Tax Form
Several forms are needed for reporting the proceeds of a DST exit.
- Form 1099-S: Provided by the sponsor and details the sales proceeds from the DST’s property disposition.
- Schedule D (Form 1040): This is the document where you’ll report your capital gains or losses based on your adjusted basis.
- Form 4797: This is the depreciation recapture form.
- Form 8824: If you’re planning to reinvest the proceeds of the DST into another 1031 exchange, this form is needed.
Your tax professional will reconcile these forms to separate the non-taxable return of capital from the taxable gain and any depreciation recapture. The result determines how much of your DST exit proceeds count as income for the year.
Wrapping Up: How DST Proceeds Are Reported
Your DST proceeds are made up of your original capital and any capital gains. Knowing the percentage of either portion is critical since they don’t undergo the same tax treatment. As you keep accurate records, you can ensure that your tax strategy remains robust and that you won’t face unexpected issues in the future.
Sources:
https://www.investopedia.com/terms/d/depreciationrecapture.asp
