Putting money into a Delaware Statutory Trust (DST) means investors reap the benefits of a passive investment. While the DST sponsor handles the ins-and-outs of direct property ownership, investors can receive regular income streams, confident in the idea that, once the DST matures and properties are sold, they’ll also likely benefit from asset appreciation.
But the downside of the trust’s maturity -- and sale of assets -- is depreciation recapture, which can be a costly surprise at tax time. As such, it’s a good idea to thoroughly understand what happens to depreciation recapture in a Delaware Statutory Trust, and what steps can help prevent the trigger of such an event.
Depreciation, depreciation recapture, and DSTs
Before continuing, it’s a good idea to take a look at how depreciation and deprecation recapture operate. The basics of depreciation are that real estate wears out, and as this happens, it decreases in value. The IRS understands this, and allows those who own property, plants, and equipment (PP&E) to write off some of that depreciation. Investors can write off the annual investment costs incurred during the approved life span of the property holding. Such depreciation also benefits DST investors. While they don’t have direct ownership responsibilities, asset depreciation flows to investors, who can use it to partially shelter cash flow from taxes.
But when that property is sold, the IRS wants its money back, and takes it through depreciation recapture. This is calculated by subtracting the asset’s sales price from the adjusted cost basis (in other words, the original amount paid for the property, along with incurred costs). Depreciation recapture is taxed at an investor’s ordinary income tax rate, which can be as high as 37%, rather than the more favorable capital gains tax rate that tops out at 20%.
So, while DST investors can benefit from depreciation write-offs during the life of a trust, they could also find themselves unprepared for the large tax burden that can take place when a trust matures, and its assets are sold.
Avoiding depreciation recapture
After reading the above, the obvious question might be: “How can I avoid triggering that depreciation recapture?” The answer to this is: Exchange. Three types of potential exchanges are listed, below.
1) An exchange into another DST or other passive investment. It’s possible to use 26 U.S. Code § 1031 - “Exchange of real property held for productive use or investment” (also known as the “like-kind exchange, or 1031 exchange) to exchange from the current, maturing DST into another one. To do this, it’s important to be sure that the replacement DST is of the same value -- or higher -- than your original investment, and that the IRS’ deadline dates are strictly followed.
2) A move into direct property ownership. DST shares can also be exchanged into physical properties, such as commercial real estate or residential assets (such as apartment complexes, duplexes, or single-family rentals). Keep in mind that this path brings the responsibility of “toilets, trash, and tenants” along with it.
3) Use of the 721 exchange. It is possible to swap DST partner shares into stocks/securities through an Umbrella Partnership Real Estate Investment Trust, also known as an UPREIT. It should be kept in mind, however, that this is a fairly complex process. An additional disadvantage is that investors can no longer exchange into other assets when UPREIT shares are sold, meaning depreciation recapture and other deferred taxes will need to be paid.
It pays to be aware
It’s important to understand that Delaware Statutory Trusts carry certain tax burdens, even as they can provide ownership benefits. The unwary investor who doesn’t stay on top of deadlines and maturity dates could find himself/herself/itself faced with a large tax burden. As such, it’s a good idea to talk with a qualified financial advisor, to build and have a plan of action in place to avoid potentially triggering depreciation recapture.
For additional information about investments in Delaware Statutory Trusts and others, call Realized Holdings at 877-797-1031, or log on to realized1031.com.
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.
There is no guarantee that the investment objectives of any particular program will be achieved.
The actual amount and timing of distributions paid by programs is not guaranteed and may vary. There is no guarantee that investors will receive distributions or a return of their capital. These programs can give no assurance that they will be able to pay or maintain distributions, or that distributions will increase over time.
