Guidance on Delaware Statutory Trusts in 1031 Exchanges
If you’re able to offer clients a bit of knowledge which gives them an advantage in a given situation, you will go a long way toward securing that client for the long haul. Being able to advise on something as complex as a Delaware Statutory Trust (DST) investment is one of those examples.
Delaware Statutory Trusts are investment vehicles which allow property to be co-owned by multiple investors. These vehicles have gained attention in many media in recent years. In this post, we will go over the benefits and drawbacks of DSTs for investors contemplating a 1031 exchange.
Because real property co-owned in a DST is considered a real property interest for 1031 exchange purposes, investors may select a DST as a replacement property. Let’s go through the most significant benefits and drawbacks of these vehicles in detail.
DSTs are an Alternative Arrangement to TICs
Before diving into the advantageous and potentially disadvantageous aspects of DSTs, let’s first mention the structure of these vehicles. Before inquiring about how these vehicles can benefit them, your clients will no doubt ask: what exactly are DSTs? One useful way to wrap you head around DSTs is to think of tenancy-in-common(TIC) ownership.
TICs are co-ownership arrangements in which multiple persons own, operate and share in the proceeds of a common property. Commercial buildings and apartment complexes are occasionally owned under a TIC ownership.
In a TIC, co-owners have an “undivided fractional interest,” which means that they are free to dispose of the property of their own volition. And this undivided fractional interest is regarded as a real property interest under the law. So, even though technically co-owners don’t own the entire property, each person owns “real estate” as a opposed to a piece of intangible personal property.
This is precisely how ownership works in a DST. The individual investors all own “real estate” (or “real property interests”) even though they only own a portion of a common property. The fact that DST ownership is classified as such has made these vehicles popular among 1031 exchange investors.
DSTs Require a Minimum Investment
One of the things investors need to be aware of is the fact that DSTs require a minimum investment. The minimum investment tends to hover around $100,000, although DSTs are obviously free to change the minimum as they please.
Most 1031 exchanges involve proceeds which are above $100,000, so this minimum won’t usually be a barrier. But, it is something to keep in mind, particularly if a DST is planning to be used as a secondary replacement property rather than a primary. If an investor needs to unload an extra $90,000 in exchange proceeds, that investor should know that outside funds may need to be brought in to obtain a DST interest.
Removing Your Investment Can Be Difficult
Another thing which prospective DST investors should be aware of is that removing your investment from a DST can be somewhat difficult. DSTs prefer to be relatively stable investment vehicles, and so once an interest is sold, DSTs typically prefer to keep the ownership structure intact for a certain period.
This may involve signing a contract which locks the investor in to the structure for a specified period of time. Or, it may involve a promise to remain with the DST unless certain contingencies occur. In any case, investors simply need to be aware that disposing of an acquired DST interest may not always be an easy proposition. For this reason, a good piece of counsel would be to say that a DST should be chosen carefully.
DSTs Provide Management for Investors
One of the benefits of a DST is that DSTs provide management for investors. DSTs have an independent management company which provides a variety of services. This distinguishes DSTs from most TICs. This allows DSTs to be relatively passive investment vehicles, even among other similar types of investment. After an investor acquires a DST interest, he or she can take a “hands off” approach and not have to worry whether the property is being managed effectively. Looking at things from an “effort to reward” perspective, this undoubtedly makes DSTs an attractive option.
DSTs Provide Low Steady Returns
Another aspect of DSTs which your clients should know about is that DSTs provide relatively low but steady returns. The typical annual return on a DST is comparatively lower than other real estate investments. The average annual return floats around 5%. However, the upside is that DSTs are more stable and therefore provide steady returns.
Many, if not most, investors will see this as a benefit, but others may prefer somewhat riskier investments which carry higher potential returns. In any case, it is something to be aware of. DSTs tend to own large, stable commercial properties (i.e. large luxury apartment communities, large commercial buildings, etc.), and so they tend to offer stability but relatively low returns. If your client wants to use their 1031 exchange proceeds to play roulette in the hope of a big return, tell him or her to look elsewhere.
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Jorgen Rex Olson is a graduate of Washington State (B.A., cum laude, 2008) and the Indiana University (McKinney) School of Law (J.D., 2012). He writes for Mackay, Caswell & Callahan, P.C., one of the leading tax law firms in New York State.