Usually, the most difficult issue our clients face when they are involved in a §1031 Exchange is finding suitable Replacement Property within the tight 45-day identification period. Particularly during a seller’s market, we hear woes of cap rate compression from nearly every investor. Then when they find a property, they still need to negotiate an acceptable price and complete their due diligence. That’s a big “to-do” list in such a short time period, and if the property they identify doesn’t work out, well, they are just out of luck. They have no choice but to pay their taxes.
One possible solution for taxpayers in such a bind is the Delaware Statutory Trust (“DST”). A DST is an Investment Trust or Land Trust that is usually formed under Delaware state law. The DST acquires institutional grade real property to be held as a passive investment. Assuming the DST is structured correctly in accordance with Revenue Ruling 2004-86, a taxpayer may acquire a beneficial interest in a DST as Replacement Property for their §1031 Exchange. For tax purposes, the transaction is viewed as the acquisition of a fractional or partial interest in the underlying property, similar to acquiring a Tenant-In-Common interest with other investors.
However, since a DST investment is viewed as a Regulation D offering by the U.S. Securities and Exchange Commission, a taxpayer must meet the SEC’s definition of an “accredited investor.” Therefore, these investments are limited to higher net worth individuals.
Assuming the taxpayer qualifies, a DST offers several advantages over other types of real estate investments:
1. Availability – At any given moment, the various sponsors offer many DSTs in a variety of marketplaces and in almost every real estate sector. Taxpayers faced with the impending expiration of their 45-day Identification Period can often identify one or more DSTs even at the last minute. Additionally, closing on a DST interest can happen very quickly and most often well within the 180-day Exchange Period.
2. Diversification – Since DSTs are available in many different regions and market segments, by acquiring DSTs taxpayers can invest outside of their local region and purchase property in a different market segment. For example, a taxpayer might exchange a six-family rental house in Brooklyn and buy a DST interest in an office park in Silicon Valley and another DST interest in a hotel in Orlando.
3. Freedom from Management – Properties held by a DST are managed by the Trustee or an affiliate of the Trustee. As a result, taxpayers acquiring DSTs can escape the management headaches of the “Three Ts”—tenants, trash and toilets!
4. Institutional Grade Property – By acquiring a fractional interest in a large property, taxpayers can invest in much larger and more expensive properties than they could otherwise on their own.
5. Investment Matching – DST properties allow the taxpayer to match the equity and debt requirements more precisely in acquiring real property of sufficient value to fully defer any gain (see Full Tax Deferral). So, if they sold their Relinquished Property for $1 Million and paid off a $500,000 mortgage, they could acquire DST investment for similar equity and debt. Additionally, since the Trust is the borrower for the mortgage on the property, the taxpayer does not need to obtain a separate mortgage, and the financing is non-recourse to the taxpayer. Additionally, taxpayers can often assume higher levels of debt, allowing them to acquire an even larger interest in the DST.
It is important to note that DST investments are still real property. As such, they are subject to the same market risks as other real property investments. Like other real estate, DSTs are also not liquid. Typically, the taxpayer should plan to be invested in the DST for five to seven years and maybe even as long as 10 years, which are the typical timeframes in which the underlying real estate would be sold allowing the taxpayer to either recognize their gain or acquire other Replacement Property through a §1031 Exchange. Acquisition and management costs for a DST may also be higher than your typical real estate investment, so it is important to ensure that the anticipated returns justify the expenses. Lastly, as there are many DST sponsors and properties available, due diligence is still a necessity before selecting any investment.
