Delaware Statutory Trust 1031 Exchange Pros and Cons
By Adam Gower Ph.D.
Real estate investing has a lot of advantages. The use of leverage to increase returns (as well as risk), significant tax advantages from“non-cash”expense such as depreciation and the ability to defer capital gains taxes through the use of the 1031 like-kind exchange have long made real estate an attractive option for savvy investors.
The rules are complicated and anyone considering using an investment that relies in any way upon the intricacies of the IRS code should seek accounting and tax advice from qualified professionals.
The following article provides information about one tool that may be used to mitigate tax depending on the individual investor's circumstances, the Delaware Statutory Trust, and is one you might ask your accountant to expound upon.
What is a Delaware Statutory Trust?
The Delaware Statutory Trust (DST) is a legal entity created and often used in real estate investing that allows for a number investors to pool money together and hold fractional interests in the holdings and assets of the trust.
While there are important legal distinctions, a DST is similar in function to a limited partnership, where a number of partners (or owners) pool investment money together for investment purposes in which a master partner will manage the assets that are owned by the trust. Similar to a limited partnership or LLC, the DST will provide owners with limited liability and pass through income and cash distributions to the minority owners.
The DST has become a widely used structure for pooled real estate investment following a 2004 IRS ruling that allowed ownership interests in the DST to qualify as a like-kind property for use of in a 1031 exchange, which allows sellers of real estate to defer capital gains.
What is a 1031 Exchange?
The 1031 “like-kind” exchange is a tool that allows a real estate holder to defer capital gains (and recapture) taxes on the sale of a property when those proceeds are subsequently invested in another like-kind property.
1031 refers to the IRS code that spells out the law and specific requirements regarding such “like-kind” transactions. The IRS is taking the view that any investment proceeds that are rolled (exchanged) into another “like-kind” investment within a certain time frame, are not actually recognizing a “gain” (profit) which would be subject to capital gains taxes.
In addition to deferring capital gains, the 1031 exchange may also allow the seller of a property to defer depreciation recapture taxes.
While the use of the 1031 has been a staple for investors for some time, the use of the Delaware Statutory Trust provides investors with greater flexibility in terms of real estate investment choices for those that would like to use the 1031 exchange.
How does a Delaware Statutory Trust Work?
Generally speaking a sponsor will set up the DST and name trustee(s) who will have sole authority to manage the business and assets of the trust. The trustees will have a fiduciary responsibility to the beneficial owners (i.e. fractional owners).
The trust will collect the investment money, arrange any financing necessary on behalf of the trust, and make and manage or hire property managers. The trust itself holds direct ownership of the assets with the individual owners owning an interest (or share) in the trust.
Similar to an LLC all income and distributions are passed through and taxed to the individual owners. The typical life of a trust can vary greatly but could easily be ten years in which property is acquired, income collected and distributed to owners and when, upon disposition of assets, remaining capital is returned to investors.
The trust provides limited liability to the trustees, managers and beneficial owners of the trust, and as a trust rather than an LLC or partnership is very simple and inexpensive for the sponsor to create and operate.
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Pros of Delaware Statutory Trust 1031 Exchange
From the perspective of an individual investor, perhaps the biggest benefit of the DST structure is that it allows a fractional interest in real estate interests to qualify as a like kind property for exchange purposes. In turn, this opens up a number investment possibilities that may not have been available to the investor. An investor who owned and managed single family home for example may roll the proceeds from the sale of that property, into a new investment class such as industrial, multi-family housing or office space through the purchase of a fractional investment.
Not only does the DST open up new sectors that may not have been available, but the structure will allow an investor to become a passive investor, and not have to worry about the day to day issues of real estate management.
While it is always possible to hire someone to manage your properties as an individual investor, when you invest as part of a DST, the management the trust will utilize will likely be of an institutional caliber. This also applies to the work and analysis done by professionals associated with the trust regarding investment and financing decisions.
DSTs are an extremely efficient form of fractional ownership for real estate. Other forms of ownership such as tenants in common (TIC) partnerships, can be cumbersome to manage. The TIC structure includes setting up individual llc’s for each investor, then must also obtain financing on an owner by owner basis. The DST structure allows for the trust as a whole to obtain financing and, dependent on how the trust is written, allows the administrators to make decisions without needing unanimous approval of owners as required in a TIC set up.
Cons of Delaware Statutory Trust 1031 Exchange
While there are many advantages of using the DST for a 1031 exchange, there are of course some drawbacks as well.
One major disadvantage of the DST ownership structure is a loss of control. The trustee or investment manager will be making all investment as well as any property management decisions. While this may be an advantage to a certain degree, for some investors not being in charge or having philosophical differences with the trust management may be an issue.
DST ownership is also a very illiquid investment.
Sure, any real estate investment is not liquid compared to investing in stocks or mutual funds, but real estate is an active market and given a reasonable time expectations an investor can decide if and when they would like to sell. While it is technically possible to sell one’s beneficiary interest in a DST, there will not be a high demand or active secondary market for your interest. As such, you are likely to get unfavorable pricing or terms on the premature sale of your interest. DST investors should be prepared to invest for the life of the trust which can be five to ten years.
A unique characteristic of the DST is that once the offering is closed, the trust cannot raise any new money, even from existing investors. While trust managers my arrange financing to meet major capital requirements during the life of the trust, it is also possible that such expenditure need to be funded from existing reserves and could potential impact the amount of income and distributions passed on to the investor. This could potentially affect total return expectations from the perspective that a certain amount of reserves may need to held back for such occasion as opposed to going directly into investment opportunity.
How to Qualify for a 1031 Tax Deferral?
The concept of the 1031 is pretty straight forward, but the actual rules can be a bit complex. The first requirement is that the property that is disposed of be of “like-kind”. Generally speaking any other real estate that is used for business purposes will qualify as like kind.
The next key component is that the exchange must be completed within a certain window of time. In fact there are two time requirements that must be satisfied. First there replacement property must be identified within 45 days of the closing of the ‘sale” property. The second key date is that the purchase of the replacement property must be completed within 180 days of sale closing. Note that both dates are keyed off of the closing date for the sale. Whether the replacement property is identified on day one or day forty-five after the sale makes no difference. The transactions must be completed within on hundred and eighty days.
The last critical element to qualifying as a 1031 exchange is that the seller of the property cannot directly receive the proceeds of the sale. Technically speaking the transaction is an exchange and proceeds and purchase must be handled by a qualified third party intermediary.
Is a Delaware Statutory Trust 1031 Exchange right for you?
A DST investment is ideal for a real estate investor who is looking to exit a holding(s) but does not want to take on capital gains exposure or another active investment management role. The DST structure will allow for a 1031 exchange to be utilized for a fractional interest in an institutional type real estate investment. The DST may also be a good choice for someone new to real estate investing, who wants the exposure to an alternative investment class such as real estate, but perhaps does not have the expertise or time to take on active investment management.
Both the 1031 exchange and the Delaware Statutory Trust are well known and extremely effective tools for real estate investors to utilize. It should be noted however that while the concepts of both are pretty straight forward, the details and execution can get a bit tricky. As such investors utilizing the 1031 and DST options should be sure to consult with real estate investment and tax professionals.
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