For those looking to do a 1031 exchange, a Delaware Statutory Trust (DST) can be easier for deferring taxes. This is because DSTs allow investors to 1031 exchange directly into the DST, bypassing the need to look for individual properties on the open market.
That may sound like a no-brainer solution to completing a 1031 exchange. However, DSTs come with risks and task implications, which can differ from those of direct real estate 1031 exchanges.
DSTs don't issue shares that can be traded on a public exchange. Instead, investors own fractional interest in the DST. This interest cannot be readily traded away at market value. Additionally, many DSTs have 5-10 years holding periods, and some will have specific resale restrictions. For those reasons, DSTs are illiquid.
However, private secondary markets are available. Still, investors trying to sell before the projected holding period may end up selling at a loss. Funds invested into a DST should be viewed as unavailable for several years.
Once a DST is closed, it can't raise new capital. If capital expenditures arise during your holding period, such as replacing a parking lot or roof, the DST cannot request additional funds from its investors. Instead, these expenses may have to be covered through the DST's (i.e., investors') profits. Depending on the expenses, such expenditures can greatly impact investor returns.
Because DSTs are passive and managed by their sponsors, investors have no say in how capex-related expenditures are handled.
Some may instead call this a hidden fee structure. However, all fees are outlined in the DST’s documents. What people are likely referring to when they say hidden fees is that DST fees are not broken out. Instead, they are bundled into the DST offering. So it may appear that investors aren’t paying any fees.
Three common fees are incurred with DSTs. These are upfront, operating, and disposition. Sponsors may also take management fees, which can come out of the DST's cash flows. Sponsors might also take a disposition/brokerage fee when selling the property.
Fees should be factored in when calculating total returns on DST investments.
Investors with no interest in managing real estate won't have a problem with loss of control. This loss of control makes DSTs passive investments and appealing to investors who don't want to be involved in property management.
We touched on this in a previous section, but it's the sponsor that makes a DST investment passive for its investors. However, investors need to ensure the sponsor is making good decisions. An experienced and knowledgeable sponsor with a good track record can instill confidence in investors.
However, investment returns are likely to suffer if a sponsor pays too much for a property. Inefficient decisions regarding debt can also impact returns, especially in a market with rising interest rates. When interest rates increase, causing debt to become more expensive, buyers will want to pay a lower cost for properties. In a dynamic market that is rapidly changing, sponsors must be quick and accurate with their decisions.
In these next two sections, we’ll go over the tax implications of DSTs.
When selling shares of a stock or investment property, profits are considered capital gains. Short-term capital gains are incurred on assets held for one year or less and taxed at the ordinary income tax rate. Long-term gains are profits realized on the sale of an asset held for more than a year and taxed at a lower rate.
Despite the risks and tax implications, DSTs can be a viable option for completing a 1031 exchange. Some DSTs will include multiple properties, providing more flexibility for 1031 exchange replacement properties. If you’re considering a DST as a 1031 exchange option, working with an experienced realtor and DST broker can help ensure a smooth 1031 exchange process.