A Delaware Statutory Trust, or DST, is a custom-designed investment structure designed specifically to provide a passive, institutional quality replacement property option for 1031 exchangers. Many current 1031 exchangers seek an alternative that qualifies as “like-kind” property for 1031 exchange, thus allowing them to avail of the substantial tax benefits of 1031, but at the same time, they would also like to retire from active management of the real estate. A DST investment satisfies these two basic requirements and allows smaller retail investors to access professionally managed institutional quality real estate investments that were previously mainly limited to institutional investors.
A DST is one of the three main options for replacement properties for 1031 exchange, the other two being to acquire a traditional piece of real estate through a real estate broker or a tenant-in-common (TIC) interest. Most DST investors started investing in real estate by purchasing, operating, and improving small rental properties either residential or retail which they acquired through a real estate broker. Direct ownership and management of real can be very profitable, but as real estate owners approach retirement age, they increasingly desire a passive option that would still qualify for the tax benefits of 1031. Thus one of the critical advantages of a DST investment over traditional fee-simple ownership is that it is a passive investment. The acquisition of the property, mortgage financing, property/asset management, maintenance or improvements during the hold and the eventual sale of the property on the back end are all handled by the DST sponsor.
The main issue with TIC ownership of real estate, through which multiple parties jointly own one piece of real estate as the tenants in common, is the need for coordination and voting among the tenants in common, which can number as many as 35. Specifically, TIC law requires unanimous approval of all the tenants for any significant decision regarding the property, such as a refinance, capital improvement, or sale. In practice, especially during difficult economic periods such as the Great Recession, this need for unanimous approval became a significant liability to the structure. In addition, because each TIC owner has deeded title to the property, they also need to be individually vetted by the lender for loan approval which is time-consuming and difficult. Due to these shortcomings in the structure, while TIC offerings had a brief period of popularity in the early 2000s, they have almost entirely been replaced by the DST structure since then.
In the case of a DST offering, the trust typically acquires the property and arranges the financing before the offering is brought to market.
The trust itself is on the deed, with the sponsor functioning as the trustee of the trust. This allows investors to quickly complete their investments without needing lender involvement. Furthermore, as the sponsor functions as the trustee of the trust, there is no need for voting or investor approval for decisions regarding the property. Of course, in this situation, vetting and selecting quality sponsors is of increased importance. Also, a typical purchase price of a DST property is in the range of $25-100 million. Thus by making a DST investment, a 1031 exchanger satisfies the 1031 requirements of 1031 exchange, can retire from active management of real estate, and has access to high-quality professionally managed properties such as apartment complexes, net leased properties, student housing, and self-storage.
The standard DST financial arrangement provides for monthly distributions from the operation of the property, and when the property sells on the back-end, the investor usually conducts a follow-on 1031 exchange, “rolling over” into a new DST. Because both the sale and acquisition closing are handled by professionals, an experienced DST investor can effectively complete their “roll-over” 1031 exchange in a matter of a few hours, mostly spent reviewing prospective replacement property DSTs.
On the more technical side, a DST is an actual trust registered in the State of Delaware according to Delaware statutory law, thus a Delaware Statutory Trust. Delaware trust law is remarkably flexible, permitting the DST structure to have certain features required by the IRS for viability as “like-kind” property for 1031 exchange, in certain particular limitations on the scope of discretion of the trustee and specific limitations on the structure itself. The investors are both grantors of the trust in that they contribute capital to the trust and beneficiaries of the trust in that they receive their pro rata share of the income distributions and sale proceeds, which rights are defined in the trust agreement.
Investing in DSTs entails significant risks that the investor must consider in advance. The bulk of these risks are those which are common to real estate regardless of the ownership structure: markets, tenants, leases, mortgage financing, rental and occupancy rates, etc., but there are also concrete risks related to the trust structure, the fact that a DST is a security, and the fact that it is a passive investment which the investor does not control.
Many investors face a capital gain tax bill ranging from 20-40% of their projected sale proceeds. The ability to indefinitely defer this tax liability via 1031 exchange is a major reason for investors to consider this option. Over 90% of the investment dollars coming into DSTs are through 1031 exchange. In addition, as 1031 exchangers are by definition, exchanging out of a real estate investment which entails significant risks into another real estate investment also entailing risks (the DST) there is not necessarily an increase in the risk profile of the investment or any change in the allocation of the investor to real estate across their entire portfolio.
Emphasizing the need to consider all the factors, risks and benefits of a DST investment with the help of a professional experienced in the field of 1031 exchange and DSTs, a DST investment can be an attractive and suitable investment consideration for 1031 exchangers.
About Trawnegan Gall
Trawnegan Gall is the Senior Vice President of Cornerstone Real Estate Investment Services and is located in Dallas, Texas. Cornerstone serves a national clientele, helping clients invest in institutional quality securitized real estate offerings, including DSTs for 1031 exchange.
Mr. Gall has brokered more than $350 million into real estate securities over the last 10 years. He is the co-author of Modern Real Estate Investing, the Delaware Statutory Trust, and is one of the field’s strongest proponents of industry best practices.
