Delaware Statutory Trusts

Everything Investors Should Know About Delaware Statutory Trusts

Investing in real estate can provide many advantages. Using leverage to increase potential returns (and risk, accordingly), combined with tax advantages such as depreciation and deferring capital gains taxes through 1031 like-kind exchanges, have long made real estate an attractive option for savvy investors.

The rules can be complicated, even for experienced investors. If you are considering using an investment vehicle that relies upon the intricacies of the IRS code — such as a Delaware Statutory Trust and a 1031 exchange — you should always consult with qualified accounting and tax professionals.

This article provides in-depth information and insight about Delaware Statutory Trusts, an investment tool many investors use to help manage tax liabilities and purchase fractional interests in commercial-grade real estate that otherwise would be beyond their means.

What is a Delaware Statutory Trust — and Why Should You Consider It?

A Delaware Statutory Trust (DST) is a real estate investment vehicle that provides individuals access to commercial investment properties that can be significantly larger than what they could acquire on their own. These properties are often the same type and quality as those owned by large institutional investors such as pension funds, insurance companies, or REITs.

DSTs provide 1031 exchange-eligibility for individual investors both upfront and upon exit, a benefit typically not available to other co-ownership structures. DSTs can also provide tax-advantaged monthly income, which may be fully sheltered from income tax liability.

DSTs are professionally managed passive investments that cover a wide range of property types, including:

• Multi-family apartment complexes
• Industrial buildings
• Self-storage facilities
• Medical office and similar types of commercial real estate

The pre-packaged nature of DSTs, combined with accessible minimum investment amounts, allows investors to create customized and diversified portfolios that can help them better manage their investment risk by alleviating ongoing landlord duties, providing recurring monthly income potential, and offering significant tax advantages.

What is a 1031 Exchange?

Real estate investors have long used 1031 exchanges to defer capital gains and other taxes. This common investment strategy allows you to sell or relinquish an investment property and defer capital gains taxes on profits by reinvesting the proceeds into a replacement asset.

Exchanges are known as “like-kind” or "tax-deferred." The name comes from Title 26, Section 1031 of the Internal Revenue Code. The history of 1031 exchanges goes back to 1921 when the IRS allowed farmers to trade or exchange one piece of farmland for another. Today, the definition of like-kind real estate generally means “property held for investment purposes.” 

Investors have turned to 1031 exchanges to defer capital gains taxes, as well as additional tax liabilities, including state capital gains taxes (in some states), Affordable Care Act surtaxes, and depreciation recapture taxes. Exchanges may allow investors to defer these taxes indefinitely provided they continually reinvest capital back into real estate — the IRS allows subsequent exchanges each time a property is sold, which allows your equity to potentially continue growing tax-free over time.

However, if you sell an investment property purchased through an exchange without purchasing a like-kind replacement, you will owe all capital gains and depreciation recapture taxes that have been deferred through previous exchanges. There also are some critical deadlines involved in the exchange process, so it’s imperative investors plan ahead before selling their investment properties.

Risks Associated with a Delaware Statutory Trust

Delaware Statutory Trusts carry many of the same risks as direct property investment since real estate is the underlying asset that drives the investment’s performance. These risks include illiquidity, as well as macroeconomic risks such as rising interest rates. These factors often increase the risk profile of real estate investments.

Due to their structure, DSTs are subject to additional risk factors that may not exist in direct property or REIT investments. DSTs are tax-heavy financial products that are exposed to a variety of additional forces, including regulatory and execution risk, as well as financial risk due to the fees that are inherent in many DST offerings.

Let’s take a closer look at risks associated with DSTs, as well as their potential to impact your investment:

Macroeconomic

Rising interest rates, as well as the overall health of the U.S. economy, can play a role in determining how investment properties perform. Increasingly expensive debt can have a downward pressure on returns, and recessionary periods can affect occupancy rates and the ability to find willing buyers.

Regulatory

DSTs are subject to various regulatory constraints from the IRS. Completing a 1031 exchange takes a great deal of advance planning to ensure the exchange remains compliant with IRS guidelines. Tax laws and regulations also are hotly debated and often amended by Congress.

Execution

DST investments involve many moving parts and interested parties. One failed step by a qualified intermediary or sponsor may affect your ability to successfully complete an exchange.

Asset-Level

Certain property types are subject to different risks and economic pressures. Examples include:

• Hotels — many have seasonal and locational risk — they are dependent on tourists with disposable income. Others, meanwhile, take in the majority of their revenue from business conferences. The economic shutdowns of 2020 demonstrate the potential for this risk to impact investors.
• Office buildings — These properties can experience increased vacancies during economic downturns and pandemics.

These two asset classes are in contrast to multifamily properties, which are often more resilient to economic fluctuation, although that depends largely on market positioning and asset class.

DST Fees

Delaware Statutory Trust transactions can be expensive since fees are typically assessed at three levels: upfront, operating, and disposition. While legal, loan, and lender expenses are typical in most real estate acquisitions, some upfront costs in Delaware Statutory Trusts aren’t as typical. These fees include:

Selling Commissions

The majority of DST investment sales are conducted via third-party selling groups. These groups include registered representatives and registered investment advisors (RIA). Since RIAs are compensated from their clients based on assets under management, commissions are typically re-allowed to registered representatives that execute sales of DST interests.

Broker-Dealer Allowance

Managing broker-dealers are often reimbursed for expenses related to their marketing and due-diligence efforts. This allowance can be in addition to other managing broker-dealer fees.

Managing Broker-Dealer

Since DSTs are recognized as securities, DST offerings are often issued through entities known as “managing broker-dealers.” When broker-dealers are involved, they typically assist in due diligence, document preparation, and securities compliance and are subsequently compensated for these efforts.

Wholesaling

Sponsor’s typically utilize in-house selling teams, known as wholesalers, who work with registered representatives and RIAs to ensure they obtain all information and documents needed to effectively sell an offering. These individuals are typically responsible for a geographical area and receive a commission for sales that occur within their region.

Offering & Organization Expenses.

These include any overhead costs associated with establishing and running the Delaware Statutory Trust, including printing costs, securities registration, and other miscellaneous costs.

Acquisition

Sometimes referred to as a “finder’s fee,” acquisition fees are payments to the Sponsor for identifying, negotiating, and acquiring the asset in the DST. Sponsors may also take an additional fee for obtaining financing for the acquisition.

Capital for fees and reserve accounts above the purchase price of the underlying asset are commonly referred to as the “load.” It’s important to consider these fees when thinking about returning 100 percent of your capital when it comes time to sell — the greater the load, the higher the underlying property in the Delaware Statutory Trust must be sold for in order to return investors’ original equity. There can be other fees over the lifespan of the DST as well, including sponsor asset management fees and disposition fees upon the sale of the property.

Pros of Delaware Statutory Trust 1031 Exchanges

Delaware Statutory Trusts offer many benefits to investors. We’ll cover these seven primary benefits:

• 1031 Exchange Eligible
• Institutional-Grade Assets
• Pre-Packaged Offerings
• Timing
• Sizing
• Diversification
• Non-recourse Debt

1031 Exchange Eligible

DSTs are typically viewed as securities under federal securities laws, so they are treated as direct ownership of real estate under Section 1031 of the IRS tax code. Thus DST investments are eligible for 1031 exchanges both when you initially invest and when the DST liquidates.

Institutional-Grade Assets

DSTs are fractional or co-investment properties that allow multiple 1031 investors to purchase equity ownership interests in large, high-quality assets that would otherwise be out of reach. By exchanging into a Delaware Statutory Trust and pooling equity with other co-owners, investors are able to own a portion of one or more institutional-grade properties that typically are significantly larger than what they could purchase on their own.

Pre-Packaged Offerings

DSTs are pre-packaged investments — the property has already been acquired, reducing the risk of missing IRS deadlines for 1031 exchanges. The DST Sponsor typically has performed due diligence, gathered pertinent documents such as property inspections, environmental reports, rent rolls and financial statements, secured financing, and installed a third-party property management team.

Timing

Timing plays a critical role in 1031 exchanges. Investors must find suitable replacement properties within 45 days of the sale of relinquished properties. Investors also must complete the acquisition within 180 days. Missing either deadline will likely result in a disqualified exchange.

Sizing

One challenge for many 1031 exchange investors is finding like-kind replacement properties that closely match the value of their relinquished assets. If replacement properties are too small or too large in value, investors may be left with excess (taxable) funds or have to come out of pocket, respectively. DSTs allow you to invest the exact amount (subject to minimum Sponsor investment amounts) necessary to satisfy exchange requirements.

Diversification

DSTs allow investors to diversify into multiple investments. Since there’s no limit on the number of DSTs investments, you can exchange into multiple properties that can provide diversification by property type and geographical location.

Non-recourse Debt

Mortgage financing is already in place when a DST includes debt. The loan, however, is typically non-recourse — your assets outside the loan are protected.

Cons of Delaware Statutory Trust 1031 Exchanges

DST investments have many positive attributes; however, they may not be a good fit for all investors. Key drawbacks include:

Inability to raise new capital/refinance

Once the DST offering closes, there cannot be future contributions by current or new investors. Major expenditures such as replacing a roof or resurfacing a parking lot can consume several year’s profits. Similarly, changes in occupancy or reduction in rents can erode a property’s cash flow.

Lack of personal control

DST’s are passive investments. DST sponsors make all decisions on your behalf, often with little to no input from you or other investors.

Illiquidity

DSTs have moderate to long-term hold periods, typically five to 10 years.

While co-ownership in DST investments is an attractive option for some investors because they offer access to high-quality institutional assets, the longer hold times associated with these investments may make them better suited for long-term passive investors.

Master Lease in a Delaware Statutory Trust

Delaware Statutory Trusts are rigidly structured — trustees cannot enter into new lease agreements with tenants or renegotiate existing leases since the Sponsor makes all decisions on behalf of the statutory trust. However, when the Delaware Statutory Trust is formed, the trust can enter into a master lease agreement wherein the whole property is leased to a master tenant.

The master tenant assumes all operating responsibilities for the property. This agreement allows the master tenant to sublease space to tenants, as well as enter into property management contracts or sub-management deals. The master tenant makes lease payments to the Delaware Statutory Trust that usually equal the required debt service and a return to beneficiaries. Master leases typically are long term with multiple options for extensions.

Master lease agreements allow for additional leasing and management activity that can potentially benefit the performance of the property while ensuring trustees remain compliant with IRS regulations.

Potential Disposition & Exit Strategies for a DST

DST’s are commonly viewed as illiquid assets due to their long five to 10-year hold times. However, investors may potentially exit the DST structure early under one of the following scenarios:

Standard or “Arm’s-Length” Disposition.

This is the most common exit strategy. In this scenario, the sponsor sells the property or properties to another party. Investors receive their pro rata share of the net sales proceeds and can either complete another 1031 exchange or pay any associated taxes.

LLC Conversion.

If a sponsor finds the DST might lose the underlying real asset due to certain circumstances, the DST can be converted into a limited liability company under Delaware state law. There is no conveyance of real property to the LLC, and the LLC is treated as a singular taxpaying entity. The partners within the LLC now can raise additional capital, seek more favorable financing, renegotiate lease terms, and enter into new lease agreements. However, since this new LLC is recognized by the IRS as the taxpaying entity, individual partners within the LLC cannot divest their shares and roll the proceeds into 1031 exchanges because individual shares are considered personal property. Sponsors do, however, retain the option of converting the LLC back to a DST in hopes of maintaining investors’ 1031 eligibility upon exit.

REIT/UPREIT.

The 721 UPREIT can be a useful tool for investors in the right situation. After holding time of at least two to three years, you can transfer your DST shares into operating partnership units of a REIT via 721 exchange. You can either hold these units and collect distributions from the REIT or transfer them for shares in the REIT, which can be liquidated. In certain DSTs, shares ultimately will be sold to a specific REIT, making all DST investors UPREITed on a tax-deferred basis.

Other DST Considerations

We’ve covered most scenarios associated with Delaware Statutory Trusts, but there are some special considerations. These include:

Divorce.

Dissolution of a marriage that involves commercial real estate assets can leave both spouses with significant capital gains liabilities if they decide to sell. However, exchanging those assets into a Delaware Statutory Trust 1031 exchange can potentially provide both parties with residual monthly income without paying capital gains tax. When the DST is dissolved, both parties can independently cash out or roll their proceeds into another tax-deferred 1031 exchange.

Innovations.

Although multi-family properties have long been the preferred asset class for DSTs, sponsor offerings also can include student housing, hospitality, self-storage, medical/commercial office, industrial warehouse/fulfillment, or single-tenant retail. Two new DST structures are changing the investment landscape as well. The first is cash-out transactions, wherein investors assume a property’s debt financing in order to access its equity. The second is a zero cash flow structure, which is based on the strength of a net-lease tenant’s credit rating. All income generated from the property is used to service its debt. While these investments may generate low income or even show a loss, investors can use that loss to offset gains elsewhere. This structure also allows investors to potentially increase their depreciable basis in a 1031 exchange.

How to Qualify for a 1031 Tax Deferral

Exchanging into tax-deferred DST replacement properties can be broken down into three steps:

1. Preparation
   Before making any strategic decisions, seek counsel from your accountant and financial advisor to ensure a 1031 exchange meets your investment goals, as well as to fully understand the cash needed to reinvest and minimum loan-to-value requirements. You’ll also have to find a Qualified Intermediary (QI) to hold proceeds from the sale of your relinquished property in escrow until you purchase a replacement. The QI also coordinates the administrative requirements of the exchange.
2. Select An Investment
   DST replacement properties are historically sold through registered broker-dealers. Since most broker-dealers only carry DST investments from a few companies, their investment offerings may not represent the breadth of opportunities available at that time. Recent regulatory changes allow Realized to offer investors an online 1031 marketplace for replacement assets, so like-kind exchange investors can browse and compare multiple real property inventory opportunities from different companies.
3. Processing, Deposit, and Closing
   After selecting one or more replacement properties, you’ll have to submit paperwork confirming you are an accredited investor. When approved, you are typically required to make a non-refundable deposit to secure your position in the investment. Then, on or before the 45th day of the exchange process, you’ll notify your QI about your choice of replacement properties. The QI prepares all necessary documents and releases your 1031 funds to the escrow agent handling the replacement asset closing.