1031 Exchange Using Delaware Statutory Trust

For this week's post, I wanted to delve into 1031 exchanges for US real estate investors with a high level overview and then dive into Delaware Statutory Trusts and how those can be used as another tool in the 1031 exchange toolbox.  I'm not a tax professional so as always, please use your own advisors and do your own research as everyone's tax situation is unique.

A Delaware Statutory Trust (DST) can be used in conjunction with a 1031 exchange to defer taxes on appreciated real estate you sell.  A DST is an entity that qualifies as "like kind" property for IRS purposes.  It allows for fractional ownership of real estate and is an alternative to buying a single replacement property and managing it yourself.  This might be a good option for people approaching retirement with significant appreciated real estate used in their trade or business, for example.  It might also be good for a long term real estate investor looking to be less active in managing the properties and looking for a more passive approach while deferring taxes.

Before I get into the pro's and con's of DST's, here's a very high level overview of the general 1031 rules:

1031 Exchange Overview

• Allows for deferral of taxes if proceeds are used to acquire "like kind property" - this could include any type of investment property for another investment property like a condo for a duplex, a condo for a small shopping center, an office building for an apartment building, etc.

• What many investors know is that long term capital gains rates are 15% or 20% (depending on your income level) for Federal purposes and vary by state, in addition:

  • Depending on your income level you may also be subject to a net investment tax of 3.8% on the gain

  • Also, to the extent you have depreciated your property your taxes on that portion of the gain (called "depreciation recapture") will be closer to your ordinary income rates (capped at 25%) which is a very unpleasant surprise for most investors

• Replacement property must be identified within 45 days of closing of sale property

• Purchase of replacement property must be completed within 180 days of sale closing

• The dates are very important and if you miss them, the transaction won't qualify and you'll be stuck with a big tax bill

• Seller must not touch the sale proceeds, so they have to be deposited directly with a qualified third party intermediary (1031 exchange accommodator) who will use the funds to close the purchase of the replacement property - it's important to work with a reputable intermediary to make sure your exchange doesn't fail to meet IRS requirements

DST Pro's

• You can free yourself from the "Three T's" of property management (Tenants, Toilets, Trash), since the DST property is professionally managed 

• Opportunity to collect monthly passive income and continue to benefit from proportionate depreciation and interest deductions passed-through to you

• Access to multi-million dollar institutional quality assets that you might not be able to buy yourself due to the high cost, including triple net leased properties (i.e., industrial building leased by FedEx under a 20 year lease), large apartment buildings, office buildings, retail centers, hotels, self-storage facilities, etc.

• Potential for non recourse debt vs recourse debt - protects investors from liability (if you own a property yourself your lender may require you to personally guarantee the debt which is recourse, vs only being able to look to the property for repayment which is nonrecourse)

• In some cases you can invest in "debt free" DST's if you don't want the added risk of debt on the property

• Potential for diversification into smaller dollar amounts:

  • Minimum DST investment can be $50K to $100K

  • Can roll, for example, $500K proceeds into fractional ownership in multiple properties through multiple DST's

  • You will need to work with a SEC/FINRA registered broker to get into these deals, but they will help select good DST sponsors and build a portfolio of properties (you can't invest in these directly as a small individual investor)

DST Con's

• No guarantee for monthly distribution or projected appreciation

• Material risks associated with real estate investments, including vacancy, market, interest rates, economy

• Completely passive beneficial interest, no right to participate in management of property

• Restrictions on trustee to protect investors ("7 deadly sins" of DST's):

  • No future contributions after closing

  • Restrictions on debt (no new loans and no renegotiations of existing debt)

  • No reinvestment of sale proceeds - up to individual investors to decide whether to take distribution or "roll over" into new DST

  • Required distributions (substantially all cash flow, except some held back for capital expenditures)

  • Limited capital expenditures (normal repairs & maintenance, minor non-structural repairs, and repairs required by law)

  • Restrictions on investment of reserves (only short term US treasuries and similar government obligations)

  • Restrictions on leases

• Illiquidity - perhaps the greatest risk in my mind

  • 7-10 year hold should be expected (until asset is sold)

  • Secondary market for DST shares, if it exists, will likely be thinly traded and you could lose money if you sell early

Not financial advice, only for information and entertainment, do your own homework.  I hope you find this post useful as you chart your personal financial course and Build a Financial Fortress in 2022.  To see all my books on investing and leadership, click here.  

Always remember: freedom, health and positivity!  

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