As you probably already know, real estate investors can use the effective tax-deferral strategy known as a 1031 exchange by reinvesting the proceeds from selling one property into another “like-kind” property (replacement property).
If you are doing a 1031 exchange to help defer your taxes, you may have a few paths when it comes to the actual replacement properties. You could always exchange into a physical property and continue to be an active landlord – multi, office, retail, triple-net lease (NNN), for example. However, you should also familiarize yourself with a passive approach. There are various passive strategies such as NNN, Tenant-in-Common (TICs) and Delaware Statutory Trusts (DSTs). To ensure a strategy fits your financial goals and plans, you must conduct research and work with a team of skilled professionals to ensure suitability and in some cases accreditation.
Many investors use a DST to execute their exchange, and the 1031 exchange process can be difficult and time-consuming. Today’s discussion will focus on educating you on how a DST can be used in a 1031 exchange to help defer your property taxes, as well as the potential pros and cons.
What exactly is a DST (Delaware Statutory Trust)?
A DST is an ownership structure under Delaware law that lets multiple investors pool their money and invest in a single property or portfolio. It allows investors to own fractional interests in the trust which owns commercial real estate holdings. DSTs are often used in 1031 exchanges to give investors a passive, turnkey option for reinvesting the money from selling a property. The DST structure has become more prevalent recently, especially among investors who want to do a 1031 exchange, because employing a DST for your 1031 exchange has several potential benefits:
Portfolio Diversification in Real Estate
Investors can diversify their real estate assets by employing a DST to carry out a 1031 exchange, which is one of the main advantages. Investors can acquire a portion of a large commercial property through a DST that they might have needed help to afford. As a result, the investor can diversify their interests across several geographical areas and property types.
Diversification is essential to managing risk in real estate investing. By spreading your investments across different properties and locations, you can help lessen the impact of a property that may do better. You can diversify your interests with a DST and still benefit from the tax advantages of a 1031 exchange.
Passive Investing
A 1031 exchange using a DST has the additional benefit of being a passive investment. An investor has no control of the property once they obtain partial ownership in a DST. The DST sponsor or manager oversees all day-to-day tasks, such as managing the property, renting it out, and keeping it in good shape.
A DST is an alternative for investors who want to take a hands-off approach to real estate investing. By buying a DST, investors can still potentially make money from the property’s possible value increase without worrying about managing it themselves.
Tax Advantages
We believe the tax advantages of employing a DST to carry out a 1031 exchange are arguably its most important benefit. Investors can defer paying capital gains tax on the sale of their investment property by arranging a 1031 exchange. Having the ability to do this enables them to reinvest the entire sale proceeds into a new property.
DSTs provide a tax benefit in addition to a 1031 exchange’s tax-deferred status. Some investors that buy more real estate by using debt in a DST, might have the advantage of a new depreciation schedule. As a result, the investor’s taxable income might be decreased, potentially lowering their tax obligations.
Professional Leadership
As was already noted, a DST is a passive investment, and property management is the responsibility of the DST sponsor or manager. Because they have much experience managing commercial buildings, these experts can use their skills to get the most out of the property.
By investing into a DST, investors can take advantage of the skilled management provided by the DST sponsor. To get the most cash potential back for investors, the sponsor will do everything possible to keep the property in good shape and rent it to the most qualified people.
Limited Liability
Real estate investing can be dangerous, as investors risk being held responsible if something goes wrong with the property. Fortunately, DST investments offer investors a degree of liability protection.
Investors who own a piece of a DST are not directly responsible for any asset’s obligations or liabilities. This means their private assets are safe if they are sued or face other legal action.
Conclusion
Using a DST to carry out a 1031 exchange has many potential advantages for investors. Investors can gain portfolio diversification by spreading their real estate holdings, using passive investment options, and having an expert manage their properties. A DST is suitable for accredited investors who want to do a 1031 exchange because it helps them defer taxes and protects them from personal liability.
The dangers associated with investing in a DST must be acknowledged, though. Investors should carefully read the DSTs private placement memorandum (PPM) to understand the investment’s risks, costs, and potential rewards.
In conclusion, as investors may have various tax deferral strategies to employ, it is highly recommended investors wishing to exchange into a DST talk to their professional team such as a qualified intermediary, tax advisor and financial advisor who has the expertise to help ensure they are making the best choice for their situation.
Disclaimer: The information in this blog post is just for general knowledge, does not constitute individual investment advice, and should not be taken as legal or tax advice Please consult the appropriate professional regarding your individual circumstance.
Because investor situations and objectives vary this information is not intended to indicate that an investment is appropriate for or is being recommended to any individual investor.
Potential cash flows/returns/appreciation are not guaranteed and could be lower than anticipated.
Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.
There are material risks associated with investing in private placements, DST properties and real estate securities including illiquidity, general market conditions, interest rate risks, financing risks, potentially adverse tax consequences, general economic risks, development risks, and potential loss of the entire investment principal.
DST 1031 properties are only available to accredited investors (typically defined as having a $1 million net worth excluding primary residence or $200,000 income individually/$300,000 jointly of the last two years; or have an active Series 7, Series 82, or Series 65). Individuals holding a Series 66 do not fall under this definition) and accredited entities only. If you are unsure if you are an accredited investor and/or an accredited entity, please verify with your CPA and Attorney.
Advisory Services offered through Asset Strategy Advisors, LLC (ASA), a SEC Registered Investment Advisor. Securities offered through registered representatives of Concorde Investment Services, LLC. (CIS), members of FINRA/SIPC. Insurance Services offered through Asset Strategy Financial Group, Inc. (ASFG). ASA, CIS, and ASFG are independent of each other.
For Accredited Investor Use Only.
Sean D. Whalen, CFP®, MSF
Published April 7, 2023
