When conducting a tax-deferred 1031 exchange, there are a multitude of options in terms of what type of property to trade into. Some investors will sell a multifamily property and buy another multifamily property, either larger or smaller than the property they sold. Others trade into different product types such as industrial and retail (NNN properties). However even with the most hands-off NNN retail property (such as a Walgreens, CVS, Dollar General etc.) where the tenant is responsible for the maintenance, property taxes and insurance, is it still really hands-off? What happens if that tenant leaves and you are left with 25,000 SF of empty space 35 miles outside of Albuquerque, NM? Enter Delaware Statutory Trusts. I have seen many of my clients trade into DSTs and while I am not advocating for or against them, below is some information about what they are and how they work.
Delaware Statutory Trusts
Delaware Statutory Trusts (DST) are not new, but current tax laws have made them a preferred investment vehicle for passive 1031 Exchange investors and direct (non-1031) investors alike. DSTs are derived from Delaware Statutory law as a separate legal entity, created as a trust, which qualifies under Section 1031 as a tax-deferred exchange.1
In 2004, the IRS blessed DSTs with an official Revenue Ruling about how to structure a DST that will qualify as replacement property for 1031 Exchanges. The Revenue Ruling (Rev. Ruling 2004-86) permits the DST to own 100% of the fee simple interest in the underlying real estate and may allow up to 100 investors to participate as beneficial owners of the property.2
How Delaware Statutory Trusts Work
The real estate sponsor firm, which also serves as the master tenant, acquires the property under the DST umbrella and opens up the trust for potential investors to purchase a beneficial interest. The investors may either deposit their 1031 Exchange proceeds into the DST or purchase an interest in the DST directly.
DST investors may benefit from a professionally managed, potentially institutional quality property. The underlying property could be a 500-unit apartment building, a 100,000 square-foot medical office property, or a shopping center leased to investment-grade tenants. Most DST investments are assets that your run-of-the-mill, small- to mid-sized accredited investors could not otherwise afford. However, by pooling money with other investors, they can acquire this type of asset.
Investors who are familiar with the tenants in common (TIC) investment strategy may see some similarities in the DST concept; however, it is important to understand the differences between the two concepts. While a TIC may have up to 35 investors, each owning an undivided, pro-rata share of the title to the property, a DST may have up to 100 investors (sometimes more), with each investor owning a beneficial interest in the trust which, in turn, owns the underlying asset.3
DST vs. TIC Ownership
There are two benefits that the DST structure offers over the TIC concept. One is that because a DST is not limited to 35 investors, the minimum investment may be much lower, sometimes in the $100,000 range. The second major advantage is that in a DST, the lender makes only one loan to one borrower: the DST’s sponsor.
In a TIC investment, the lender can fund up to 35 separate loans, one to each investor.3 In times of tight money, however, the DST gives the lenders greater security because the lender has fully qualified the sponsor, who is the underlying responsible party.
Be aware that the higher number of investors, plus the larger number of shares, may or may not protect your investment; careful scrutiny of the controlling partner/sponsor is advised. There are a lot of crooks in this business.
DSTs are not without risks. As with any real estate investment, investors may be subject to high vacancy rates and loan defaults. It is also important for investors who may be considering the DST strategy to consult with an experienced investment professional and obtain competent legal and tax advice. The DST structure may be a viable investment alternative for qualified real estate investors, but only your tax adviser and a lawyer can tell you if it is right for you.