InSight

Pros, Cons, and Risks in a Delaware Statutory Trusts (DST)

Financial Planning Dentist

Delaware Statutory Trust Pros:

As an income source:

DSTs are popular with people in general who wish to develop some diversity in their investment portfolio by introducing some real estate components. People like being able to count on the specific return and appreciate not having to deal directly with tenants. They are also extremely popular with 1031 exchange investors for the same reasons but also due to the fact that it can be difficult to identify replacement property within 45 days of the sale of their relinquished property and they have certainty of closing within the applicable 180-day window. 

As a source for replacement debt (for 1031’s):

Most investors participating in a 1031 Exchange require the new investors to have a prorated portion of the debt to be able to replace the portion lost when relinquishing the property. The debt is non-recourse to the investor but allows the investor to hold new debt equal to or greater than the debt retired upon the sale of the relinquished property. A DST can make being assigned this debt an easy prospect. 

The transfer of the relinquished property to the Qualified Intermediary and the receipt of the replacement property from the Qualified Intermediary is considered an exchange. To be compliant with IRC Section 1031, the transaction must be structured appropriately, rather than being a sale to one party followed by a purchase from another party.

As a backup plan (for 1031’s):

Exchange investors also sometimes use a DST as a backup in case the primary identified property falls through or the primary property acquisition does utilize the entire exchange value. The DST purchase can absorb the balance.

Delaware Statutory Trust Cons:

Like any real estate investment, DSTs have traditional risks associated with them. Real estate risk, operator risk, interest rate risk, and liquidity risk are all common risks associated with the DST investments. The sponsor does due diligence as does the back office of the broker or adviser’s firm, but so should the investor. 

Asymmetrical Risk:

The prospectus typically does a good job of pointing out other risks of each such individual investment. But the location of the investment, the building type and local market, and the quality of the sponsor are all important non-idiosyncratic risks investors should be familiar with in DST investing. 

Real Estate Risk

While it is regulated and sold as a security, at its core, DSTs are real estate, and the risks of any real estate investment apply. Real estate risk in this context is exactly equivalent to the real estate you presently own, including your own home. The local market can drop, the economy can decline, or weather and catastrophe can befall an investment. All of these events will affect the condition, income and expense, and eventual sales price of the property.

This is not a risk that is without mitigation. This risk can be diversified by selecting a portfolio of real estate with different building types, locations, and management expertise that understand how to best insure and stagger certain forms of risk.

Ensuring you have a well-diversified portfolio in growing markets is one way to mitigate real estate risk. And investors shouldn’t underestimate the importance of spending sufficient time at the outset to ensure the property is a good investment and that it fits well into their InSight-Full® financial plan. 

Operator Risk

A risk unique to DST investors is operator risk. Poor management in all real estate lowers both the income performance and the long-term capital return. When the property is not managed at an optimal level, return is always affected. Both a Property Manager and an Asset Manager manage DSTs, and each is assigned to different roles. 

A quick review of how management duties are divided: the Property Manager’s job is to implement the business plan, increase income, and lower expenses. As a result, net operating income will increase over time. 

The Asset Manager watches the property as if he owned it himself, managing the Property Manager with the same goal of increasing net operating income as much as possible, which increases your cash flow and appreciation potential. The Asset Manager also watches the market for sales opportunities and decides when it’s time to sell, reports to investors periodically, and is responsible for keeping the investors abreast of what’s going on with the property and answering any questions.

Liquidity Risk:

Most Real estate investors have long-term views of their holdings. However, DSTs are somewhat illiquid once acquired and may carry liquidation penalties to accommodate an early exit. So all investors should be prepared to stay invested for the term of the deal and have a long-term disposition if the DST is part of a multicycle tax mitigation scheme.

Managing liquidity might be the most important way to manage your exposure to real estate. Having a good idea of our expectations on liquidity can help manage other forms of risk in real estate. For example, investors in the early stages of a bear market who can “wait out” market conditions by lowering their liquidity requirements might find they can outlast negative consequences from other forms of risk.

Static Debt:

One challenge of a DST structure is that the property cannot be refinanced after the initial loan is in place nor can a lease be revised for a single tenant property. These factors are usually dealt with before the DST formation but sometimes the issues may arise later. If so, solutions can be complicated and expansive. Most sponsors will not change the debt structure of a deal once it is closed.

Tax Status and changes to Taxation:

As your income and taxation change in life, so too might the success and valuation of your tax mitigation strategy. It’s important to evaluate your long-term goals and expectations and work with a CFP® to make sure the tax scheme makes sense over a range of scenarios. 

According to the IRS and Revenue Ruling 2004-86, 1031 exchanges that use a DST are structured investments. This revenue procedure includes guidelines for taxpayers preparing ruling requests. They are only guidelines, however, and are not intended for audit purposes.

Remember, laws change, which means that different tax provisions may come into play today, and may create liabilities and penalties if they are not completed accurately or as laws change. 

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