Using a 1031 exchange to exit your current investment real estate ownership can help defer capital gains taxes and depreciation recapture. Thanks to the IRS Revenue Ruling 2004-86, you can use fractional shares offered through a Delaware Statutory Trust (DST) as part of your exchange strategy.
Targeting DSTs as a part of your like-kind exchange process could offer many benefits. There are drawbacks to consider as well. Understanding the pros and cons can help determine if a DST investment suits your financial goals.
Internal Revenue Code Title 26, §1031 (“Exchange of Real Property Held for Productive Use or Investment”) allows you to exchange your investment real estate (relinquished property) into a like-kind property of equal or greater value (replacement real estate). When done correctly, the 1031 exchange can help defer capital gains taxes and depreciation recapture while allowing you to potentially upgrade your assets.
The above-mentioned Revenue Ruling 2004-86 means DST shares can be used as a like-kind exchange replacement property. DSTs are legal entities that buy investment real estate and then sell shares of the trust (fractional interests) to others. While fractional interests aren’t technically “hard” real estate, for all intents and purposes, they’re treated as such when used as part of a 1031 exchange.
If you decide to exchange investment real estate for DST shares, you move from direct to indirect property ownership. This means you could receive passive income while leaving the tasks of real estate ownership to the DST sponsors. In addition to hands-off ownership and potential tax deferral benefits, other advantages to a DST acquisition include the following:
Access to institutional-grade real estate. Due to smaller capital availability or access, direct property ownership could limit you to small, single properties. On the other hand, a DST investment could funnel your dollars into institutional assets that could boost the potential for higher income.
Professional management. Because the properties are managed through the DST, you don’t have to do so. The managers are generally experienced in generating asset value, which could help improve property appreciation.
Limited liability. You’re not personally responsible for the DST’s debts or obligations. If the trust is sued, your personal assets aren’t in danger. Financial risk can be contained, with your exposure limited to what you invest.
Property vetting. The DST’s professional staff has performed its due diligence on the property it acquires. You won’t have to research and analyze the property. Nor would you have to negotiate the property’s purchase. However, before investing, you should research the DST’s financials, track record, and reputation.
The qualities that can make a DST investment a positive experience–hands-off ownership–can also present a challenge. As a DST investor, you have no say in managing the properties; the sponsor makes the decisions.
Other potential challenges with DST investments include:
High fees. DST sponsors charge high fees for property acquisitions, dispositions, and management. These expenses can reduce your expected income.
Limited liquidity. A DST’s holding period can last as long as ten years, tying up your capital for a lengthy period. Additionally, there are no secondary markets for buying or selling your DST shares, meaning your money is in the trust until it dissolves unless the sponsor offers a redemption option.
Macroeconomic risks. A DST's underlying investment is real estate, which is subject to interest rate movements and economic cycles that can impact occupancy rates and property dispositions.
Regulatory issues. DSTs are subject to various regulatory constraints. Furthermore, Congress continually debates and amends tax laws and regulations, which could impact DST performance.
Determining whether a DST fits your investment objectives requires due diligence on various factors. Before directing money to a DST, investors may consider the following steps:
Thoroughly evaluate each offer. Carefully assess each DST offering for information about the sponsor’s track record, projected returns, occupancy rates, and exit strategies. Study the DST’s private placement memorandum to get a feel for the sponsor's activities.
Review the underlying assets. In addition to researching the DST, the underlying property must be evaluated. Study the asset’s performance, geographic location, maintenance history, and current condition.
Work with DST experts. DSTs are complex investments that require expert guidance and may help clarify potential risks and investment suitability. Professionals like the Realized 1031 team can offer resources and insights to navigate the challenging DST terrain while reducing the chances of errors.
A DST can provide tax-deferral and passive income benefits as part of the 1031 exchange process. However, completing a like-kind exchange with a DST carries its share of challenges. It can be daunting to perform due diligence on the DST’s sponsor while complying with the IRS’ 1031 exchange requirements.
If you need help with the process–or want to learn more–reach out to the experts at Realized 1031. These professionals have the knowledge and understanding to assist you with a successful like-kind exchange.
Visit realized1031.com for your no-obligation consultation.
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.