1031 Exchange vs. Delaware Statutory Trust (DST)
The concepts on real estate investing can be tricky, especially if you don’t know the basics of each. Here, we have rounded up information about 1031 Exchanges vs. Delaware Statutory Trusts (DST).
Real estate investing has some advantages to boast, such as:
- The use of leverage to increase returns;
- Significant tax advantages from “non-cash” expenses such as depreciation;
- The ability to defer capital gains taxes to the use of the 1031 like-kind exchange have long made real estate an attractive option for investors.
What is a 1031 Exchange?
1031 exchanges refer to the IRS code that provides the law and specific requirements regarding “like-kind” transactions. Like-kind transactions allow real estate professionals to grow and diversify their portfolios, with limited federal income tax implications. To qualify under Section 1031, there must be an exchange of real property held for the productive use in a trade, business or investment solely for property of a like-kind for practical use in a trade or business or investment.
Investors have turned to 1031 exchanges to defer their capital gains taxes, as well as additional tax liabilities, which, in some states, include state capital gains taxes, Affordable Care Act surtaxes, and depreciation recapture taxes. 1031 Exchanges may permit real estate investors to perpetually defer these taxes provided that they continually reinvest capital back into other forms of real estate. In fact, the IRS allows subsequent exchanges each time a property is sold, which allows an investor’s equity to continue growth potentially. At the same time, be tax-free unless such investment is alienated, transferred, or sold.
What is a Delaware Statutory Trust (DST)?
A Delaware Statutory Trust is a mode of real estate investment that provides individuals with an avenue 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 purchased or owned by large institutional, corporate, or government investors, such as pension funds, insurance companies, or REITs.
DSTs provide 1031 exchange eligibility for individual investors upon entry and exit, a benefit not commonly available to other co-ownership structures. Moreover, DSTs can also provide tax-advantaged monthly income, which could be fully sheltered from income tax liabilities. Simply put, DSTs are professionally managed passive investments. They cover a wide range of property types, including, but not limited to the following:
- Industrial Buildings;
- Multi-Family Apartment Complexes;
- Self-Storage Facilities;
- Medical Offices and other similar types of commercial estates.
It is vital to note that Delaware Statutory Trusts are viewed as securities under Federal law and qualify as a like-kind exchange under Section 1031 of the IRS tax code.
Advantages of Delaware Statutory Trust (DST) 1031 Exchanges. Delaware Statutory Trust (DST) 1031 Exchanges offer many benefits to Investors. The following are its advantages:
- 1031 Exchange Eligible. DSTs are customarily viewed as securities under the federal securities laws. Hence, they are treated as direct real estate ownership under Section 1031 of the IRS tax code. Accordingly, the DST investments are eligible for 1031 exchanges both when it is initially invested and when it is liquidated.
- Institutional-Grade Assets. DSTs are compartmental or co-investment properties that allow numerous 1031 investors to acquire equity ownership interests in significant, high-quality assets that would typically be out of reach. By exchanging into a Delaware Statutory Trust and merging equity with other co-owners, 1031 investors can own a portion of an institutional-grade property that is significantly larger than what they could ordinarily purchase on their own.
- Opportunities for Diversification. Since a person can choose the amount to be invested in a Delaware Statutory Trust, he can split his investment between and among multiple DST properties, thereby allowing the opportunity to diversify his real estate portfolio and, therefore, lessen the risk of a loss.
- Earn normal distributions. Delaware Statutory Trusts are allowed to keep a reasonable amount of cash reserves to be prepared in case of a contingent event that would necessitate repairs or face unexpected expenses. However, all earnings and proceeds above the reserve amounts must be appropriated to the beneficiaries on a routine basis and within an expected period.
- Sizing. One of the challenges for 1031 exchange investors is finding like-kind replacement properties that closely match the value of their alienated or transferred assets. If replacement properties are too small or too large in value, investors may be left with excess, and therefore, taxable funds. However, DSTs allow an investor to invest a definite and exact amount necessary to satisfy exchange requirements.
- Non-recourse Debt. Mortgage financing is already in place when a DST includes debt. The loan, however, is typically non-recourse, i.e., the investor’s assets outside the loan are protected.
Disadvantages of Delaware Statutory Trust 1031 Exchanges:
- Lack of Control. With Delaware Statutory Trusts, investors can still enjoy the benefits of owning real estate without dealing with the day-to-day responsibilities of actively managing real estate. Although this may be a plus for some, others do not want to give up their management responsibilities. With a DST, investors do not have operational control or have the ability to make management decisions.
- Inability to raise new capital/refinance. Once the DST offering closes, there won’t be future contributions by current or new investors. Major expenditures such as changing or refurbishing a roof can consume several year’s profits. In the same vein, changes in occupancy or diminution in rents can destroy or lessen a property’s cash flow. This means property maintenance can eat up a large chunk of profit. Hence, it is essential to have reserves that are set aside in advance.
- Not liquid. DSTs have moderate to long-term hold periods, typically five to 10 years. And therefore, they are not liquid, i.e., quickly sold for cash.
Conclusion. The 1031 exchange and the Delaware Statutory Trust are well known and highly effective tools for real estate investors to utilize. However, it should be noted that while the concepts of both are pretty straightforward, the details and execution can get a bit tricky. As such, investors utilizing the 1031 and DST options should consult with real estate investment and tax professionals.
While the information at hand can be overwhelming, there are many ways in which you can simplify your understanding of 1031 exchanges and DST’s. Choose the best commercial broker and company to help you understand the ins and outs of these concepts.
Even after outlining all the information above, investing in CRE and the 1031 Exchange process can still seem daunting. That’s why the Leveraged CRE Investment Team at Commercial Properties, Inc. is here to help you achieve your investment goals. Contact us at (480) 330-8897 or send us an email at firstname.lastname@example.org.
Need help on your 1031 Exchange? We got you covered! We prepared a free e-book that will serve as your guide to achieve your long-term business goals or obtain that property you’ve always been dreaming of!
Phill Tomlinson is a commercial real estate broker with Commercial Properties, Inc. (CPI) in Scottsdale, Arizona, and owner of the Leveraged CRE Investment Team specializing in investment sales and tenant/landlord representation in the Phoenix and Scottsdale submarkets. Phill applies over 21 years of experience in the Real Estate industry helping investors and owners maximize their returns.
Bookmark www.leveragedcre.com to learn more about the Commercial Real Estate market and keep informed of relevant real estate strategies designed to maximize your income property investment results. Connect and follow Phill on Social Media at sm.leveragedcre.com/smplatform. #LeveragedCRE