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A Complete Guide to DST 1031 Exchange

February 27, 2024

Acquiring investment properties through the 1031 exchange helps you defer capital gains taxes on the sale of old property. But do you know you can also qualify for tax deferrals when you invest in Delaware Statutory Trusts? You can combine a DST investment with the 1031 exchange strategy to maximize tax deferral benefits while growing and diversifying your portfolio.

Delaware Statutory Trusts (DSTs) is a unique investment structure within the 1031 exchanges that allows multiple investors to pool their funds to own apportioned interests in real estate assets. However, executing a successful DST 1031 exchange requires a proper understanding of how it works. So, it’s best to consult with an experienced Qualified intermediary to help you stay compliant.

With over 32 years of experience in facilitating 1031 exchanges, our 1013 exchange qualified intermediaries at Universal Pacific 1031 Exchange have the required experience to guide you through a smooth and compliant DST 1031 exchange. We’re always available to answer your questions and facilitate your exchange. Schedule a DST 1031 Exchange consultation with us today to get started.

This guide aims to help you understand DSTs, the process, benefits, potential drawbacks, the financial risks involved, tax implications, and how to find the right DSTs amongst others. 

Understanding Delaware Statutory Trusts (DSTs) in 1031 Exchanges

Understanding Delaware Statutory Trusts (DSTs) in 1031 Exchanges

A Delaware Statutory Trust (DST) 1031 exchange refers to a type of investment strategy that combines the use of a Delaware Statutory Trust with the tax deferral benefits of a 1031 exchange in the United States. A DST 1031 exchange is made up of two main components: the DST and the 1031 exchange. Let’s break down these key components:

According to Section 1031 of the Internal Revenue Code, the 1031 exchange allows an investor to defer capital gains tax on the sale of an investment property. To qualify for this tax deferral, you must reinvest the proceeds in a “like-kind” replacement property.

Delaware Statutory Trusts, on the other hand, allow for fractional ownership of property. Instead of investing the sale proceeds of the relinquished property directly into a replacement property, they invest in a DST which gives them fractional ownership of the replacement property. This structure enables multiple investors to own a share of a single property or a portfolio of properties.

Combining these two, a DST 1031 exchange allows an investor to sell a property, defer capital gains taxes by using a 1031 exchange, and reinvest the proceeds into shares of a DST that owns one or more real estate properties. This can be an attractive option for investors looking for passive income, as the DST is managed by professional managers who handle all aspects of property management and operations.

Key Features of a DST in Real Estate

Key Features of a DST in Real Estate

DSTs offer several unique features that make them an attractive option for most real estate investors looking to diversify their portfolios and potentially defer taxes on capital gains. Here are the key features of a DST in real estate:

Fractional Ownership

DST investors own a proportional share or fractional interest in the entire trust, which in turn enables them to own the real estate properties. This allows individual real estate investors to participate in the ownership of larger, potentially more profitable properties than they might be able to afford or manage on their own.

Passive Investment

Since a DST real estate portfolio is managed by professional managers or sponsors, DST investors do not have direct involvement in the day-to-day management or operations of the property. So, if you’re looking for passive real estate income streams without the complexities of property management, the DST 1031 exchange is for you.

Limited Personal Liability

As with other trust structures, investors in a DST typically enjoy limited personal liability. Their risk of loss is generally limited to the amount of their investment in the DST, protecting personal assets beyond the invested capital.

Flexibility in Acquisition and Financing

DSTs can hold a single property or a portfolio of properties as they offer flexibility in investment strategies. They also offer the potential for easier financing arrangements, as lenders deal with the DST as a single borrower rather than multiple individual investors.

Eligibility for 1031 Exchanges

One of the most significant advantages of investing in a DST is its eligibility as a suitable replacement property for investors looking to execute a 1031 exchange. Investors can defer capital gains taxes by reinvesting the proceeds from the sale of an investment property into a DST holding real estate.

The Process of a DST 1031 Exchange

The Process of a DST 1031 Exchange

Understanding how this strategy works helps maximize the combination of its component strategies. Below is a breakdown of the process:

  1. Sell the Relinquished Property: To initiate the 1031 exchange process, sell the relinquished property. Remember that the properties involved in the transaction must be commercial real estate assets. They must be held for investment or business, not personal use property.
  2. Choose a Qualified Intermediary (QI): Select an experienced Qualified Intermediary before closing the sale. The QI will hold the proceeds from the sale to prevent constructive receipt by the investor, which is crucial in deferring capital gains taxes.
  3. Adhere to the IRS Timeline for 1031 exchange: After the sale of your investment property, you have 45 days to identify potential replacement properties. Commercial real estate investors can identify more than one potential replacement property as long as they comply with the applicable IRS rules. Examples of IRS rules for identifying multiple properties include the 200% rule and the three-property rule.
  4. Reinvest the Sales Proceeds in a DST: To fully defer all capital gains taxes, you need to reinvest all of the proceeds from the sale into the DST(s). The property you invest in must be of equal or greater value than the sold property. You must also communicate this decision in writing to the qualified intermediary within the 45-day identification period.
  5. Complete the Exchange: You have a total of 180 days from the sale of the original property to complete the purchase of the replacement property, in this case, the DST interest. Note that the timeline runs concurrently with the 45-day identification period.
  6. Transfer of Funds: The QI transfers the proceeds to the DST, finalizing the purchase of the DST shares on your behalf. The QI also helps in proper documentation and prepares closing statements to reflect the completion of the exchange, including the transfer of investment into the DST.
  7. Reporting: You must report the DST 1031 exchange on the IRS Form 8824 with your tax return for the year in which the exchange occurred.

Financial Requirements For Entering a DST 1031 Exchange

Financial Requirements For Entering a DST 1031 Exchange

To enter a DST 1031 exchange, there are certain financial requirements you must meet. These requirements come both from regulatory perspectives and those set by the DST sponsors. They include:

Minimum Investment Amounts: DSTs often have minimum investment requirements that can vary significantly depending on the trust and the properties it holds. Minimums are typically around $25,000 to $100,000, but they can be higher. This threshold ensures that accredited investors are genuinely capable of contributing to the property’s collective ownership.

Accredited Investor Status: Many DSTs admit only accredited investors. This means they must have a net worth exceeding $1 million, excluding the value of their primary residence. Alternatively, an accredited investor must have an income exceeding $200,000 ($300,000 for joint income) for the last two years with the expectation of the same or higher income in the current year.

Sufficient Equity and Debt Replacement: To fully defer your capital gains taxes in a 1031 exchange, you must reinvest all of the net proceeds from the sale of your investment property into the DST. Additionally, you need to replace the debt on the relinquished property with either new debt in the DST or additional equity.

Liquidity Requirements: Some DSTs and 1031 exchanges might have liquidity requirements to crosscheck that investors have enough liquid assets to cover their investment and any unforeseen expenses. Investments in DSTs are generally illiquid. So, make sure you have sufficient liquidity outside of your DST investment to cover your needs without relying on the ability to quickly sell your interest in the DST.

Tax Implications and Planning: Ensure you have a clear understanding of the tax implications of a DST 1031 exchange, including the requirements for deferring capital gains taxes and the impact on your overall tax situation. You may need to consult with a tax professional who has experience with DSTs and 1031 exchanges to handle these complexities effectively.

7 Common Financial Risks Associated With DST 1031 Exchange and How to Minimize Them

7 Common Financial Risks Associated With DST 1031 Exchange and How to Minimize Them

Investing in a Delaware Statutory Trust (DST) as part of a 1031 exchange offers several benefits, including potential tax deferrals and access to high-quality real estate investments. However, it also comes with its own set of financial risks. It’s best to understand these risks and how to minimize them to maximize the benefits of the strategy.

1. Lack of Liquidity

DST investments are usually not liquid; you’d have to plan with exit strategies for several years into the future. Hence, you may have issues if you need access to your investment capital sooner. Ensure you have enough liquidity outside of the DST investment to cover emergencies and other financial needs.

2. Reliance on the Sponsor’s Management

Real estate investors in a DST rely heavily on the sponsor (manager) for property selection, management, and eventual sale. Poor management can lead to suboptimal returns or even losses. Research the sponsor’s track record, including their experience, past performance, and reputation in the industry. Look for sponsors with a strong history of managing DSTs and delivering on their promises.

3. Interest Rate and Financing Risks

Changes in interest rates can affect the financing costs of the property held within the DST, potentially reducing cash flow and distributions to investors. Consider DSTs with properties that have long-term, fixed-rate financing in place to reduce exposure to fluctuating interest rates.

4. Market and Economic Risks

Real estate markets are subject to cycles, and economic downturns can negatively impact property values and rental incomes. Look for DSTs that invest in properties with strong underlying fundamentals and in markets with potential for growth and stability.

5. Tenant Risks

The financial situation of tenants and their ability to pay rent can directly impact the DST’s income. It can be worse if a significant portion of the property is leased to a single tenant or to tenants in the same industry. Look for DSTs with properties that have a diversified tenant base, multifamily apartment buildings, or that are leased to tenants with strong credit profiles.

6. Regulatory and Tax Law Changes

Changes in regulations or tax laws can also affect the advantages of investing in a DST, such as the potential loss of 1031 exchange benefits. It’s recommended to stay informed about potential regulatory and tax law changes. Additionally, work with a knowledgeable tax advisor or qualified intermediary to understand how these changes may impact your investment.

7. Capital Call Risk

Some DSTs may have provisions that allow for capital calls if additional funds are needed for property improvements or to cover unexpected expenses. Review the DST’s offering documents to understand the conditions under which capital calls can be made and assess your ability to meet them if required.

How to Choose the Right DST 1031 Exchange

How to Choose the Right DST 1031 Exchange

Before choosing a DST for your investment portfolio, it’s necessary to carefully consider various factors to ensure it aligns with your financial goals, risk tolerance, and investment strategy. Follow this guide to select the right DST:

Assess Sponsor Reputation and Track Record: Look for sponsors with extensive experience in managing DST investments and a solid track record of performance. Also, confirm that they have experience in the specific type of real estate within the DST. Moreover, research the sponsor’s reputation in the industry, including any regulatory issues or lawsuits they may have faced.

Understand the Property Type and Market: Different types of properties – residential, commercial, industrial – come with different risk and return profiles. Choose a property type that fits your investment goals and risk tolerance. Secondly, consider the geographic location and market characteristics of the property, including demand and supply factors, economic growth, and employment trends in the area.

Review Financials and Projections: Evaluate the projected cash flow and distributions. Understand the assumptions behind these projections and assess whether they’re realistic. Look into the property’s financing, including loan terms and interest rates. Prioritize properties with stable, long-term financing in place to mitigate interest rate risk.

Diversify Your Portfolio: Properties with a diversified tenant base can offer more stable income streams. Be wary of properties that depend only on a single tenant. Consider DSTs that provide exposure to different geographic areas and sectors to reduce risk.

Legal and Tax Considerations: Ensure that the DST’s debt is non-recourse to investors, limiting your personal liability. More importantly, verify that the DST is structured to comply with IRS requirements for 1031 exchanges to ascertain the deferral of capital gains taxes.

Analyze the Exit Strategy: Understand the sponsor’s planned hold period for the property and ensure it aligns with your investment timeline. Look for a clear exit strategy for the property, including potential market conditions for sale, to ensure you can liquidate your investment when you want.

Consider Fees and Expenses: Carefully review all costs associated with the DST, including management fees, acquisition fees, and any other expenses that could impact your returns.

Consult Professionals: Speak with registered investment advisors familiar with real estate and DST investments to get an unbiased opinion on the suitability of a DST for your portfolio. Also, consult with legal and tax professionals to understand the implications of investing in a DST, especially regarding 1031 exchange rules and potential tax benefits or liabilities.

Conclusion

Especially for investors looking for passive ownership and management of commercial real estate, a DST 1031 exchange provides an opportunity to grow your investment tax-deferred. But before you launch the strategy, be sure to understand all it takes to avoid costly mistakes. The best way to start is to consult with a reputable QI experienced in this kind of exchange.

Universal Pacific 1031 Exchange Los Angeles Office has been in the industry for over 32 years, so you can trust we have the experience to help you. Schedule a free 1031 consultation with us today!

About The Author

Michael Bergman, CPA
Michael Bergman is a California licensed CPA and Real Estate Broker with over 32 years of experience in commercial real estate. Specializing in 1031 tax-deferred exchanges and financial oversight, his expertise is invaluable for complex real estate transactions. Michael’s unique blend of financial acumen and real estate knowledge positions him as a trusted advisor in the industry, offering sound advice and strategic insights for successful property management and investment.

Don’t let taxes hinder your property investment decisions. Connect with us today for a free, no-obligation 1031 exchange consultation. Let us help you navigate the process with ease.