Here at Realized, we help our clients use 1031 Exchanges to invest in DSTs, or Delaware Statutory Trusts. DSTs are an investment vehicle that allow investors access to fractional ownership of professionally managed commercial real estate. By having fractional ownership of a property, an investor can potentially build a unique portfolio of real estate investments without having to manage the properties themselves or secure the entire financing for the investment upfront.
While DSTs offer plenty of potential benefits for real estate investors, they can also be tricky to manage during tax season as they work differently from traditional real estate investments. Something an investor must calculate while doing the taxes for their DSTs is the depreciation schedule on properties involved in a 1031 Exchange. In a recent webinar, Realized covered key terms and calculations to know as you process your DSTs during tax season. In this blog, we’ll discuss the ways that DST depreciation schedules differ from direct property investments and how to calculate these depreciation schedules.
What Are Depreciation Schedules?
Depreciation schedules are used to calculate an asset’s loss of financial value over time for accounting purposes. Properties naturally lose value over time, so we use depreciation schedules to account for this loss of value when you calculate your taxes.
There are many different ways to calculate a depreciation schedule. A straight-line method is the most common approach for real estate properties, but there are many other strategies you can use as well. The straight-line method assumes that your property depreciates at a consistent rate for a set period of time - usually 27.5 years for residential properties and 39 years for commercial properties.
The Realized Depreciation Schedule
Realized has its own depreciation model for properties that have been through 1031 Exchanges. Investors don’t have to use this model, but we have found that it can be beneficial to do so in some cases. Ultimately, you will need to work with your CPA to determine which depreciation schedule works best for you.
There are key differences between the Realized depreciation schedule and a traditional depreciation schedule. The Realized depreciation schedule is designed for investors who have used a 1031 Exchange to invest in a share of a DST, while a traditional depreciation schedule would be for those who have used an exchange to buy property directly.
The biggest difference is that the Realized model assumes a 30-year depreciation schedule, rather than the standard 27.5 years. A provision in the 2017 Tax Cuts and Jobs Act limits certain interest expense deductions while using standard depreciation. However, these limitations do not apply if you are using 30- or 40-year depreciation schedules.
We also view the DST as a pass-through entity, which means that tax benefits must be passed through in proportional interest to the beneficiaries. This allows for annual depreciation allowances that are greater than they would be in a direct property exchange. With a traditional direct property exchange, you would calculate the depreciable basis from the inception of the purchase and apply the corresponding depreciation schedule. With the Realized model, the depreciation schedule starts with the full cost basis, and then each beneficiary of the DST can take proportional allocated depreciation deductions.
To calculate your depreciation schedule with the Realized model, you’ll start with your proportional trust basis. We’ve discussed how to calculate this in previous blog posts, which you can reference here. Then, you will apply the standard improvements vs. land assumption rate of 85 percent to calculate your depreciable basis. We then apply a depreciation schedule of 30 years, which results in your annual depreciation allowance.
Potential Benefits of Realized Depreciation Schedule
The Realized depreciation schedule may provide benefits for investors who have used a 1031 Exchange to invest in a share of a DST. Again, investors don’t have to use this model, but we have found that it can be helpful for those who are in this situation. Although the Realized model has a longer depreciation schedule than the standard model, it may result in a higher amount of depreciation overall, which can help reduce your taxable income and increase your after-tax cash flow in the short term.
DSTs can be tricky to process during tax season, but understanding these depreciation schedules can make calculations easier. Every investment is unique, which is why it is important to consult with your CPA as you file your taxes. If you don’t have a trusted CPA, feel free to reach out to the Realized team for recommendations.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
