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An Alternative or Back-up for the 1031 Exchange

Financial Planning Dentist

The Delaware Statutory Trust (DST) is a trust that is structured as a pass-through entity and can hold passive Real Estate. It can function as a 1031 Exchange Alternative. All of the debt is nonrecourse and the income, net of expenses, is distributed to the investor. 

What are the advantages?  

  • 1031 Exchange compatibility
  • Passive investment with no management responsibility
  • Estate planning tool – pass DST on to your heirs, tax deferred

Who benefits from them?

  • Investors no longer wanting to manage real estate
  • Retiring real estate investors
  • Backup/ alternative option for 1031 exchanges
  • Investors looking to diversify into properties typically unavailable to them

A Delaware Statutory Trust is a legal entity used to arrange for the co-ownership of property. DST’s are a great vehicle when constructing real estate offerings as co-owners are entitled to profits earned from the property, like rent, without the management responsibilities. For many it can be a 1031 Exchange Alternative.

So why do people use DST’s? Let’s say you have an investment property that you’ve held for a long time and because you’ve depreciated the property for a number of years your basis is very low and the property has grown considerably simultaneously. Well you’d have a large capital gain on your hands if you sell it. You could do a 1031 exchange (1031 Exchange)  but that means getting another investment property, following a number of rules, and doing it in a short amount of time. Although very doable, looking at a more passive strategy may benefit you. 

If you want your capital to be invested from your home without losing a majority of it to capital gain taxes and are accustomed to cash flow from your rentals then deferring your gains and reinvesting your capital into like-kids real estate can be done through a 1031 exchange. You may also decide to hire a third party management company to take the day-to-day responsibilities away as well which although cuts into your income, saves you from the downside of being a landlord.

If you’re the one being a landlord, want to expand your investment portfolio, and want cash flow then the DST is the best of both worlds alternative where you don’t have to choose between paying taxes now or being a landlord. With the DST, you get passive income, capital grows free of capital gains tax, you avoid being a landlord, and you get diversification. Let’s walk through how you’d do this.

First, you’d make use of the 1031 exchange by swapping the proceeds from your real estate sale of your investment property for interest in a DST. By doing this, you become co-owners/investors in a diversified portfolio of properties and pass the management responsibilities on to the sponsor who acts as the trustee for the DST. This satisfies your IRS responsibility of finding a “like kind” property and enabling you to defer capital gains. 

DSTs provide you limited liability protection, regular (at least quarterly but often monthly) cash flow income, high-quality assets, and 1031-compatibility. Since with any trust there is a trustee (takes legal title for purposes of management) and a beneficiary (takes equitable title). DSTs are pass through entities, so as a beneficiary, this structure entitles you to a fractional share of income, appreciation, and tax benefits from the properties.  This structure is key for 1031 eligibility as the acquiring property must be “like kind” to your sold real estate and even though you don’t hold legal title, for tax purposes, you’re treated as owning that property.

Since the DST is a separate legal entity, beneficiaries have limited liability and therefore any debts incurred by the DST won’t put the investors personal assets in harm’s way. It also protects personal assets from the liabilities of other owners and the DST itself. 

DSTs are the only statutory trusts to be explicitly recognized by the IRS as legal entities that can facilitate a 1031 exchange. 

What are the risks of DST’s?

  • Macroeconomic risks
    • Economic downturn can mean lower returns and income
  • Liquidity risks
    • Most DST’s have an investment period of 7 to 15 years
    • Although you get cash distributions your principal is off limits during this time
  • Management risks
    • A bad sponsor may pick overvalued properties when compared to peers 
    • A low yield while the investor is still collecting fees for management and organizing the investment
    • Do your due diligence to check the sponsors history, background, and how similar deals have done in the past to see if projected return rates were met and problems due to bad management didn’t occur
    • High vacancy rates and unforeseen costs hurt cash flow
  • Financing Risk
    • DSTs are managed differently but if the trustee uses high loan to value offerings there is a higher risk of foreclosure
    • Fully amortized loans need to be paid by the end of the loan agreement so that could affect your cash distributions
  • Eligibility
    • The DST needs to be structured to facilitate your 1031 Exchange Alternative

In conclusion, DST’s when done properly, are a great way of getting away from being a landlord or paying a large sum of capital gains taxes while simultaneously giving you the passive income, limited liability, 1031 compatibility, and high quality asset diversification. However, just because it does all these things doesn’t make it a great investment. They require proper due diligence to review the sponsors reports, loan documents, appraisals, underwriting data, etc prior to investing.

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