Delaware Statutory Trusts (DSTs) for 1031 Exchanges

Real estate owners looking to sell existing real estate and acquire new real estate will commonly use a 1031 exchange to defer capital gains taxes. However, this strategy comes with stringent deadlines and requirements.

A Delaware Statutory Trust (DST) is an increasingly popular option that can provide real estate sellers with more flexibility and a wider range of investment choices. This article will explore how a DST operates with respect to 1031 exchanges and why it can be an attractive alternative to traditional property ownership.

Key Takeaways

• A DST is a flexible vehicle that allows real estate investors to defer capital gains taxes through a 1031 exchange.
• ADST must be structured as a passive investment trust, adhering to strict rules that limit the trustee's operational control.
• DSTs offer a streamlined, passive ownership model and allow investors to own a fractional interest in institutional-grade properties, unlike the more complex and unanimous decision-making required for a Tenancy-in-Common (TIC).
• Investors in a DST are treated as direct owners for tax purposes, receiving a grantor trust letter to report their share of income and expenses on their personal tax returns.

What is a Delaware Statutory Trust (DST)?

A DST is a legal entity – a trust formed and governed under Delaware law. It’s created by filing a Certificate of Trust with the Delaware Division of Corporations. It is designed to hold title to real estate, with an unlimited number of investors (beneficiaries) owning fractional interests. When structured correctly for a 1031 exchange, the IRS treats a DST as a “grantor trust”, meaning the investors are considered to be direct owners of the underlying real estate for tax purposes.

The creditors of investors (beneficiaries) have no right to obtain property belonging to the trust, and the beneficiaries have limited liability similar to corporate shareholders. The rights of the trustee are generally limited to the collection of rent or sales proceeds and the distribution of the net cash flow to the beneficiaries.

How Do DSTs Work in a 1031 Exchange?

To qualify as a “like-kind” replacement property for a 1031 exchange, a DST must adhere to a set of rules established in Revenue Ruling 2004-86. These rules (the “Seven Deadly Sins”) prevent the DST from being classified as a “business trust,” which would make it ineligible for a 1031 exchange:

1. No additional capital contributions are permitted after the DST offering is closed.
2. The trustee cannot refinance or renegotiate the existing loan or place new debt on the property.
3. The leases on the property cannot be modified or a new lease entered into unless the tenant is insolvent or in bankruptcy.
4. All cash, less reserves, must be distributed at least quarterly.
5. Reasonable reserves retained by the trust must be held in short-term investments or government securities.
6. Capital expenditures are limited to normal repair and maintenance, non-structural improvements, or bringing the property into compliance with legal requirements.
7. Sales proceeds cannot be reinvested.

These rules make sure that the DST operates as a passive investment vehicle and satisfies the requirements for a 1031 exchange.

Use in Sec. 1031 Exchanges

Typically, the real estate is acquired by the trust, while the DST sponsor owns all the trust's interests. The sponsor then sells the trust units to investors as replacement property to complete their Sec. 1031 exchanges or as outright investments. The rights to income and deduction transfer to the unit holders starting with their closing dates. Their percentage of ownership is fixed and does not change on the sale of additional units to other investors. The DST can own a single property, but more commonly owns a portfolio of properties. The DST can be leveraged for all cash.

DST vs. Tenancy-in-Common (TIC): Which is Better?

Both DSTs and TICs are structures that allow multiple investors to own a fractional interest in a property for a 1031 exchange. However, they have some important differences.

The passive nature of a DST makes it a popular choice for investors who want to simplify their real estate portfolio and avoid the complexities of managing a property directly or coordinating with a large group of co-owners.  It also provides relief from the stringent time period requirements applicable to locating and closing on replacement property in 1031 exchanges.

DSTs are similar to tenancy-in-common (TIC) ownership, but there are significant differences. TIC ownership is also restricted in the rights and obligations of each owner. However, unlike a DST, a TIC owner can directly transfer a portion of the TIC property.

In a TIC, the TIC owners must act unanimously to make decisions involving the property's operations, whereas in a DST, the trustee acts on behalf of the trust. To obtain IRS approval to be treated as a TIC rather than a partnership, the TIC may have no more than 35 owners. There is no limit on the number of DST owners. Accordingly, DSTs tend to own larger assets than TICs.  In addition, if the DST is leveraged with non-recourse debt, each beneficiary assumes its pro-rata share of the debt, and the debt qualifies if required as part of the 1031 exchange.

Tax Reporting for DST Owners

The owner of an interest in a DST generally receives a grantor trust letter, as opposed to a Form K-1 or Form 1099, with the necessary information to report its share of the property’s income and expenses. Since depreciation is based on each individual owner’s tax basis from their exchange, the DST does not provide information relating to depreciation deductions. The DST may, however, provide the percentage classification for depreciation purposes (land, building, land improvements, and personal property).

Each investor must report both the 1031 exchange and the income and deductions arising from their DST ownership on their respective tax forms. 

Is a DST Right for Me?

DSTs are becoming increasingly popular among investors completing 1031 exchanges, offering an interesting alternative to direct ownership of replacement property.

Because there are certain time limitations for a taxpayer looking to acquire “like-kind” property in a 1031 exchange, acquiring an interest in a DST may be a viable alternative. For taxpayers looking to sell real estate, structuring a DST as a sponsor may open up an additional market of buyers.

Ready to explore if a DST is the right fit for your investment strategy? Contact us today for a consultation with our real estate team.