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.
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.
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.
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.
Several forms are needed for reporting the proceeds of a DST exit.
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.
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