Investment in a Delaware Statutory Trust (DST) could offer a few benefits:
- Potential capital gains tax deferral. Keep in mind DST investments are illiquid, and exiting early may not be possible.
- Fractional ownership in potential income-producing real estate.
- Hands-off management structure. This does, however, come with a lack of control over management decisions and property disposition.
However, just because you’re involved with a DST doesn’t mean you’re free from tax implications. As with any investment, understanding DST tax requirements is crucial to avoid surprises and possible penalties.
A Brief DST Overview
The DST is a legal entity that buys, finances, manages, and sells investment real estate. As an investor, you own fractional shares of the trust rather than the actual real estate on behalf of its investors. This means the DST is a passive income model; while the trust’s sponsors manage the real estate, you could receive regular income. You might also reap the advantages of property appreciation when the DST ends by selling the real estate it owns.
However, the DST doesn’t pay any income or capital gains taxes at the entity level. As an investor, you are responsible for paying those taxes at the federal and state levels.
Taxes on Distributed Income
A DST’s primary cash flow comes from rent. Additional cash-flow sources might include paid amenities like on-site ATMs, parking, storage, or food and beverages. Wherever that cash flow originates, it’s considered taxable income when it hits your bank account.
At the federal level, DST cash flow is taxed at the ordinary income tax rate. How much you owe depends on your specific tax bracket, which could be as high as 37%. Furthermore, depending on where you live, you also owe state taxes on that income.
Taxes on Capital Gains
The assumed goal of DST property is that it will appreciate. When the trust sells the property due to dissolution, you receive your share of any capital gains. You also assume the tax burden (unless you follow a tax-deferred strategy like investing the gains in another DST or real estate).
In most cases if the property has appreciated, you’ll owe capital gains taxes on these proceeds. The capital gains tax rate could be as high as 20%, depending on your ordinary income tax bracket. Those capital gains could also be taxed at the state level.
Depreciation Recapture Taxes
One benefit of DST fractional ownership is depreciation deductions from income. If the DST holds onto the property (and you remain a fractional owner), this process can help reduce your taxes.
However, the IRS wants some of that depreciation back when the DST dissolves and realizes a gain when selling its real estate assets. This process is known as depreciation recapture. Depreciation recapture is taxed at a maximum rate of 25%, while any remaining capital gain from appreciation is taxed at capital gains rates (15% or 20%), depending on income level. If an investor exits the DST and cashes out, they will owe both capital gains tax and depreciation recapture tax. Investors can defer both depreciation recapture and capital gains tax by rolling their DST proceeds into another 1031 exchange property or DST investment.
Know What You Owe
Investment in a DST can generate many benefits. With those benefits come responsibilities, including tax payments. Understanding what you owe on income and capital gains can help you comply with the IRS tax rules while avoiding unexpected fees and penalties.
Working with tax professionals knowledgeable about DSTs and other fractional investment forms is always a good idea. Realized 1031 experts are on hand to provide the guidance necessary to navigate DST tax requirements.
For more information or to schedule a consultation, visit the website at realized1031.com.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
