by: HUDSONPOINT Team | October 31, 2021
Delaware Statutory Trusts (DST) provides real estate investors with one of the most efficient ways of obtaining tax-efficient, fractional ownership interest in commercial real estate. A DST is similar to a limited partnership in that a group of investors (otherwise known as partners or beneficiaries) acting as minority owners contribute capital and resources to the trust, where the master partner (or sponsor) then manages the assets and holdings that the trust owns.
A DST can hold title to multiple properties in several locations at once, similar to a REIT (Real Estate Investment Trust). In return for their capital and resources, the minority owners receive limited liability, a pro-rata share of income and cash distributions, and access to commercial real estate investments for which they may otherwise lack the capital.
The use of the DST for commercial real estate investors grew in popularity in 2004, after the IRS ruled that ownership interests in a DST qualify for the tax benefits granted by a 1031 exchange, or “like-kind” exchange, a tool that allows real estate sellers to defer capital gains tax by rolling proceeds from one real estate investment directly into another within a set timeframe.
DSTs incentivize the growth of real estate wealth not only through the passive, hands-off nature of their investments but through their tax benefits, low costs of ownership, and diversification potential.
DST investors can invest in just about every type of commercial real estate property, including multi-family housing, industrial real estate, retail buildings, office spaces, and even specialty property types such as medical offices and self-storage units.
An individual investor who owns a single-family home leases it out, and manages it entirely by themselves may see similar or greater returns from the commercial real estate investments offered by DSTs minus the woes of property management and other components of hands-on investing.
The 1031 exchange has historically been a popular way for individual real estate investors to defer and recapture capital gains tax by reinvesting the proceeds from one sale into another.
The 1031 exchange was originally introduced as part of The Revenue Act of 1921 under Section 202(c); after multiple revisions, in 1954, an amendment to the Federal Tax Code changed the section applicable to tax-deferred, like-kind exchanges to Section 1031 of the Internal Revenue Code.
Now, since their 2004 ruling, the IRS allows DST investors to claim the same tax benefits granted to individual investors using 1031 for a sale and, as a result, preserve all of the sale’s equity. These benefits apply as long as the proceeds from the sale of a relinquished property are reinvested into a “like-kind” replacement property of equal or greater value within 180 days of the relinquished property’s closing date.
Unlike other ownership structures like the tenant-in-common (TIC) agreement, investors in DSTs are not required to maintain any type of individual legal structure on their own. The State of Delaware does not charge any type of ongoing fee for the creation and management of a DST either, and investment minimums can run as low as $100,000 for 1031 exchange investors and $25,000 for cash investors.
It’s also more difficult for investors in a tenant-in-common agreement to obtain financing from lenders since each co-owner in the agreement is also a co-borrower. The sheer amount of paperwork involved in acquiring these loans often turns lenders away from TICs.
This is not the case, however, with DSTs. They’re financed with non-recourse debt and their investors, given their purely passive relationship with the trust, are not responsible for any liability on loans. All debt liability falls on the shoulders of the DST’s
sponsor.
Delaware Statutory Trusts give access to commercial real estate investments for which most individual investors would otherwise lack the capital. Combining that with the fact that the investors themselves don’t actually have to do any of the property scouting and securing work makes portfolio diversification even easier for DST investors.
The rental income that DST properties generate is distributed directly to the investors’ bank accounts on a monthly basis, and investors can expect anywhere between a 5% and 9% cash-on-cash monthly rate of return.
Despite their benefits, DSTs face illiquidity due to real estate being their primary underlying asset with long-term hold periods of 5 to 10 years. DSTs are also vulnerable to macroeconomic trends, such as rising interest rates and periods of recession, that tend to put downward pressure on earnings.
The IRS puts a great deal of strain on DSTs in the form of regulatory constraints; for example, to benefit from a 1031 exchange, you need to plan several months in advance to ensure compliance with IRS guidelines, and a single mishap can halt the entire process.
Despite their benefits, DSTs face illiquidity due to real estate being their primary underlying asset with long-term hold periods of 5 to 10 years. DSTs are also vulnerable to macroeconomic trends, such as rising interest rates and periods of recession, that tend to put downward pressure on earnings.
The IRS puts a great deal of strain on DSTs in the form of regulatory constraints; for example, to benefit from a 1031 exchange, you need to plan several months in advance to ensure compliance with IRS guidelines, and a single mishap can halt the entire process.
Similar to commercial real estate investments in and of themselves, Delaware Statutory Trusts are sensitive to the debt cycles of the economy and how much it costs to borrow money. Investors should stay informed on monetary policy and monitor moves made by the Federal Reserve to keep a healthy track of their investments, no matter how passive.
Remember that no debt liability falls on the shoulders of the trust’s beneficiaries, so at the very least, minority owners don’t have to worry about making loan payments in spite of poor investment property performance.
The tax laws and regulations that govern DSTs top the list of debate topics adored by Congress. Combine this with the fact that DST transactions often involve many moving parts and you have a sales process that halts at the first sign of weakness, delaying cash flow and successful completion of the exchange.
If your DST has investments in other states outside of Delaware, you’ll have to file a state income tax return with each state wherein your trust has investments, increasing expenses on your part as your CPA takes time to prepare and file each one.
While the costs of ownership for a DST are lower than other ownership structures, some of the upfront transaction fees you’ll encounter as an investor in a DST are atypical. These include:
These aren’t the only types of fees you may encounter as an investor in a DST, but they’re some of the most common.
As with any investment, there are risks involved in a DST. Risks such as mismanagement of the portfolio, poor use of leverage/capital, and a collapse of the portfolio. Understanding these risks and performing your own due diligence prior to investing in a DST can minimize these risks.
Originally posted on HudsonPoint
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