Beyond the passive income and tax-deferral benefits offered by Delaware Statutory Trusts (DSTs), investors find these investments appealing because of the promised predictability and stability. However, nothing is set in stone in real estate investing, and there are times when sponsors initiate a property sale before the agreed-upon holding period is over.
Early DST property dispositions are driven by market conditions and material events. In most cases, the untimely sale will be favorable to investors. However, it’s crucial to understand the impact of the early property sale to better prepare and manage implications on tax liability and your overall investment strategy. Realized 1031 shares what you need to know.
There are two reasons why early disposition may be initiated by the sponsor.
Early sales can unravel years of planning for investors. Sponsors do notify beneficial interest owners for such initiatives, but you could still end up unprepared.
The most immediate impact would be the disruption to your income stream, even though you may receive higher distributions. As such, budgeting for a gap period may become necessary if you don’t have other income sources.
However, the most concerning impact happens to those who entered the DST through a 1031 Exchange. The 1031 Exchange follows strict timelines, and you may be time-constrained if you plan to reinvest into another DST to preserve your tax-deferred status. As such, communication and coordination with your sponsor are crucial to plan ahead of time and avoid losing your tax-deferral benefits.
There are a few ways a sponsor can conduct property disposition in a DST. You should see these routes in the offering memorandum.
The most common practice is a DST sale, where the sponsor sells the underlying assets and distributes the proceeds plus the original invested capital to the beneficial interest owners. If your sponsor decides to go this route, and you’re still planning to continue another 1031 Exchange, they cannot directly deposit the distributions to your personal accounts. Instead, they must coordinate with your qualified intermediary to prevent direct control of the capital and preserve your 1031 eligibility.
The other option is an umbrella partnership real estate investment trust (UPREITs) conversion or a 721 Exchange. This strategy involves contributing the DST assets to the trust, and the investors receive operating partnership (OP) units equivalent to the total amount of their capital in the DST.
UPREIT conversions are ideal for investors who no longer want to continue 1031 Exchanges. This option is also tax-deferred, and you only become liable for the deferred capital gains taxes once you begin converting OP units to REIT shares. Since UPREITs and DSTs follow a similar passive nature, you can still enjoy hands-off management and heightened diversification. Also, since OP units can be converted in increments, you have more control over tax payments.
For early DST property disposition, UPREITs help reduce time constraint shock. There are no deadlines with 721 Exchanges compared to 1031 Exchanges.
Revenue Ruling 2004-86 prohibits DSTs from refinancing debt to maintain the passive nature of the investment. However, refinancing is still possible as an alternative to an early sale, especially when the assets are underperforming, and the DST cannot pay debt services. Since DSTs cannot refinance, the trust must be converted into a springing LLC. This step is a taxable event, but it is necessary to preserve your initial investment. As such, if your sponsor takes this step, you must be prepared for the tax hit.
Refinancing is extremely rare, so you’re unlikely to experience one. Still, choosing an experienced sponsor and a DST with realistic promises and financial projections helps reduce the chances of this event happening.
While unexpected, early DST sales usually happen because of highly favorable market conditions that lead to higher investment returns. This event can occur regardless of the agreed-upon holding period, leading to unplanned changes to your overall investment plan. As such, it’s important to maintain clear and constant communication with your sponsor in case they have plans to take this route. That way, you can preserve your 1031 Exchange cycle or prepare for the cash flow gap.
https://www.irs.gov/pub/irs-drop/rr-04-86.pdf
https://www.loopnet.com/cre-explained/finance/what-is-a-721-exchange/
https://turbotax.intuit.com/tax-tips/investments-and-taxes/1031-exchange-how-it-works/c998pvsTp