“Why didn’t my realtor know about this?” At Tactical Income, Inc., we hear that question often when consulting on Delaware Statutory Trust (DST) investments for a 1031 exchange. We heard this from a client in San Diego with nine investment properties and serious medical problems who no longer had the time or energy to manage her properties but didn’t want to deal with property management companies and didn’t want to lose 30% in taxes right up front when selling her investment properties. She chose to do a 1031 into several Delaware Statutory Trusts.
We also heard this question from a hard-working IT specialist with four rental properties who wanted to move his investment equity into more passive investments so he and his wife could travel the world. He also chose to sell his properties and 1031 exchange into DSTs.
Knowledge of DSTs Can Lead to Listings
Typically, the best realtors are honest, self-motivated problem-solvers who can listen and adapt to their clients’ needs. In order to do this, it requires knowledge, experience, and a few extra tools in their back pocket. Realtors who truly want to serve their clients and help generate listings should know about Delaware Statutory Trusts (DSTs).
Read on to learn about Delaware Statutory Trusts and how DSTs can help realtors generate listings and better serve their clients, especially clients from the “baby boomer” generation who are entering retirement.
What is a DST?
Let’s start with the basics. Delaware Statutory Trusts (DSTs) are generally represented by institutional quality properties or portfolios of properties that owners can exchange their investment property into while also deferring capital gains taxes by performing a tax-deferred 1031 exchange.
Despite the name, Delaware Statutory Trust investments aren’t just for Delaware. They can be offered throughout the United States and can include a wide range of property types, including commercial and retail buildings, industrial properties, medical offices, multi-family apartment complexes, single-tenant rental properties and more.
A DST is a separate legal entity formed as a trust under Delaware law that, if properly structured, will be classified as a grantor trust for federal income tax purposes and, as a result, the purchaser of a beneficial interest in the trust will acquire an undivided interest in the asset(s) held by the DST. Delaware Statutory Trusts are structured so that each beneficiary (investor) owns a beneficial interest in the trust. The managing Trustee of the DST is either the Sponsor or an affiliate of the Sponsor.
The DST holds title to 100% of the interest in the property. Tax reporting for a DST is done on a Schedule E utilizing property operating information provided by the Sponsor.
Many seasoned investors in their 50’s, 60’s, 70’s and 80’s own highly-appreciated real estate assets and income properties. As these real estate investors enter retirement, many would prefer to no longer deal with the hassles of property management, including maintenance problems, tenant disputes, rent checks, vacancies, and leases. Hiring a property management company can help with many of the day-to-day tasks, but it can still require a lot of involvement from the owner.
If you’re a realtor with any clients in this type of situation, you may want to discuss with them the potential benefits and drawbacks of a Delaware Statutory Trust 1031 exchange. If your client decides to move forward with a DST, you can help them sell their current investment property (thus creating a listing), and then they can reinvest the proceeds into a Delaware Statutory Trust through a tax-deferred 1031 exchange.
Ownership in a DST offers the typical benefits and risks an investor would receive as a single large-scale investment property owner, but without the responsibility of managing the properties.
DST properties are managed by professional investment real estate asset managers and property managers. A DST may provide some of your clients with a worthwhile opportunity to move their investments into a more passive investment portfolio with added benefits. For realtors, this also helps create a real estate listing if your client decides to sell their current investment property and invest in a DST.
Other Benefits of Delaware Statutory Trusts
In addition to tax deferral benefits through 1031 exchanges, DSTs can also offer the following benefits:
- Low Minimum Investments: Delaware Statutory Trusts typically have relatively low minimum investments starting around $25k. A low minimum investment provides smaller investors with an opportunity to own a portion of a large, professionally managed commercial property along with other investors, not as a limited partner, but as an individual owner within the Trust. As part of a DST, each owner/investor receives their percentage share of the regular cash flow income, tax benefits, and potential appreciation (if any) of the entire property.
- Diverse Portfolio of Properties: Another reason your clients may want to consider a DST is that the cash proceeds from the sale of a single investment property can be exchanged into multiple DSTs. This allows for a diverse portfolio of properties, which can be diversified by a variety of fund sponsors, property types, or geographical locations. This diversification can help to reduce the risk associated with concentrated assets.
- Estate Planning: DSTs may also be effective for estate planning, since they can be easily inherited by beneficiaries, who will avoid paying taxes altogether as they will receive the asset on a stepped-up tax basis.
What Else to Know About DSTs
The IRS issued the Revenue Ruling 2004-86 that set forth parameters a DST must meet in order to be viewed as a grantor trust and qualify for a viable tax deferring vehicle. If the DST is structured responsibly, the parameters do not prohibit a successful business plan for a property. The following is a list of the parameters and the procedures generally accepted to comply with these limitations:
- The DST may not purchase additional assets other than short-term obligations. All cash from the property is held in liquid money market type accounts.
- The DST may not accept additional contributions of assets.
- There can be no additional capital calls to the DST. As part of the due diligence, the Sponsor conservatively anticipates the amount needed to properly maintain the property over the holding period and that amount is included in the initial capital raise.
- The DST may not renegotiate the loan terms and/or the loan may not be refinanced. The Sponsor has negotiated the loan terms for the property prior to acquiring the property. In the event the property is not sold before the loan matures, there are provisions in place to convert the DST to a limited liability company (“Springing LLC”). This allows the Trustee (Sponsor) the ability to take the necessary actions to remedy the situation if, for example, the property needed major capital improvements (not allowed within the DST structure) or the loan needed to be refinanced. This action will limit investors’ ability to conduct another 1031 exchange upon the sale of the property.
- The DST may not renegotiate leases or enter into new leases. The investors, through the Trust Agreement, enter into a Master Lease with the Trustee in order to avoid having to renegotiate leases or enter into new leases with the actual tenants.
The DST may not make major structural changes. Any major improvements will be done or have been done by the seller prior to the Sponsor purchasing the property. Normal “turn-over” expenses
- fall within the DST guidelines and do not create an issue with the DST structure. Diversification does not insure a profit or guarantee against a loss.
- The DST must distribute all cash, other than the necessary reserves, to the beneficiaries.
- The DST may not sell or exchange property and reinvest the proceeds. The DST structure does allow for the investors or beneficial owners to conduct their own 1031 tax deferred exchange once the DST has liquidated its assets (i.e. sold the property).
DST Potential Drawbacks
A DST investment is an investment in real estate; any investment in real estate is subject to market value and rental income fluctuations, tenant issues, vacancies, taxes and governmental regulations. There are costs and fees associated with a DST investment and management and the tax benefits must be weighed against the investment costs.
A DST owner does not maintain management control or dictate day-to-day property management operations. DST ownership is also subject to additional IRS regulations that affect the management of the property and your ownership interest.
DST investments are highly speculative and involve substantial risks. No public market is likely to exist for such investments, so it should be understood that there is a lack of liquidity. DST investments are not freely transferable and substantial restrictions may apply to the transfer of interests.
Is a DST 1031 Exchange Right for Your Client?
If you’re a realtor who wants to know if a DST 1031 Exchange is right for your client, or if you just want to learn more about how DSTs may be a helpful tool to create listings, please contact Don Meredith, President of Tactical Income Inc. in San Diego, CA.
Don Meredith has specialized in real estate tax strategies with an emphasis on advising on 1031 Exchanges since 1999. He has published numerous articles on investing, has lectured extensively on 1031 transactions and Delaware Statutory Trusts, and his book will be published soon titled The DST Revolution – The New 1031 Exchange Option.
Contact Don Meredith of Tactical Income, to learn more about Delaware Statutory Trusts (DSTs) and 1031 Exchanges at: [email protected] or (619) 726-6100.