5 Things Every Investor Should Know About DSTs for 1031 Exchanges

Savvy real estate investors know about the 1031 Exchange. This swap of one real estate investment property for another is a part of the tax code — it gets its name from section 1031 of the Internal Revenue Code (IRC). A 1031 Exchange is a powerful tool for landlords and other real estate investors: when an investor wants to sell an appreciated property and buy another, it can cause capital gains taxes to be realized.

One of the most desirable aspects of a 1031 Exchange for many investors is that the exchange makes it possible for these taxes to be deferred, rather than being realized when a sale takes place. This process has become so popular for real estate investors that it has almost become its own verb — “let’s 1031 that building for another!”

Many real estate investors are aware of 1031 Exchanges and may have considered an Exchange for themselves. As popular as 1031 Exchanges are, not every investor understands how a Delaware Statutory Trust, also known as a DST, can give investors an opportunity to complete their Exchange differently, and potentially change the way they invest in real estate overall.

DSTs and 1031 Exchanges, like many aspects of the tax code and real estate investing, can be complex. A broker or financial advisor can be a great ally to investors looking to understand how a 1031 Exchange or a DST might help them reach their investing goals, based on their tolerance for risk and their situation. Curious about how a DST could work with a 1031 Exchange? Here are five things to know about DSTs and 1031 Exchanges.

1. A DST is considered like-kind property

1031 Exchanges allow property owners to defer taxes on capital gains by selling their appreciated real estate and buying other like-kind property instead of selling for cash and paying taxes.

It’s a common misconception that like-kind, in the context of a 1031 Exchange, means the properties being exchanged must be the exact same type: for example, a multifamily building being exchanged for a multifamily building.

This isn’t actually the case, though. Like-kind properties in this context are properties that are held for investment purposes or business use. Most real estate held for investment purposes is considered like-kind. DSTs are included in this definition of like-kind. Assets like personal homes or vacation homes, on the other hand, are not generally eligible for 1031 Exchanges.

Since DSTs are considered like-kind property, it’s possible to exchange a single property you own for a DST, which could be made up of a portfolio of many properties. A DST could also be exchanged for another DST.

    2. A DST is a different way to invest in real estate

    A Delaware Statutory Trust is a fundamentally different way to own and invest in real estate. Rather than investing in properties by purchasing them outright, a DST investor holds undivided fractional interests in the holdings of the trust. This trust is initially established by a DST sponsor, who identifies and acquires the assets included in the DST. Investors have a beneficial interest in the trust — they have a percentage of ownership, and no single owner can claim exclusive ownership over any particular aspect of the real estate owned by the trust.

    What does this mean for investors? Their beneficial interest in the trust entitles them to a pro rata share of any income or loss of income generated by the property held by the DST. If an investor owns a larger percentage of the DST, their share of the income or loss of income will be greater. The same goes for any appreciation or loss of value generated by property held by the DST. This means a DST has the potential to become a stable cash flow for investors.

    These potential benefits are available to DST investors without many of the headaches that come with active management of real estate properties. Properties owned by DSTs are professionally managed, giving investors access to a truly passive way to invest in real estate.

    3. DSTs can add flexibility to 1031 Exchanges

    In a 1031 Exchange, a common strategy for identifying replacement properties is the “3-property rule,” where the exchanger identifies within 45 days up to three properties for their Exchange, without regard to their fair market value. The exchanger then has 180 days to close on one of those three properties.

    Identifying multiple properties makes it more likely that an Exchange will be successful, even if one or two of the properties identified falls out of escrow for any reason — financing issues, failed inspections, or other issues. It’s always good to have a backup plan.

    Because DSTs are fractional investments in property, the amount invested into a DST is more customizable than it is when a property is purchased outright. Rather than searching for a property that exactly (or as closely as possible) matches the value of the property being exchanged, an investor can choose how much they want to invest in a DST. Investing in a DST naturally gives investors more flexibility when executing a 1031 Exchange.

    An investor can benefit from this additional flexibility by simply exchanging a property owned outright for a DST that is “right sized” to meet their needs in the Exchange.

    If an investor’s goal is to Exchange one property for another, and successfully closes on one property but is left with some “boot” — uninvested cash or relinquished debt that could be taxable — investing in a DST can also be a useful tool in this case. When used as a replacement property in an exchange, a DST can be used to make up for the difference in values between two properties in an exchange, ensuring that no capital gains are realized.

    4. DSTs can be an estate planning tool

    1031 Exchanges are well-known as a way to delay the realization of capital gains when an investor wants to sell a property that has appreciated in value. What’s not as well-known is how 1031 Exchanges and DSTs can work together to be a powerful tool for estate planning and protecting your legacy for your heirs.

    Throughout your lifetime, you can accrue unrealized gains across multiple 1031 Exchanges. If these gains are exchanged into new properties, no capital gains will be realized at the time of the 1031 Exchange. This may give you greater potential for investments than if your tax liability had been paid on a current basis.

    When it’s time for your assets to be passed on to your heirs, they will inherit them with a “stepped-up” tax basis: the cost basis will be based on the value of the assets when they are inherited. This means your heirs continue to defer capital gains taxes as long as they continue to hold the assets.

    When your heirs are inheriting DST investments through this process, there are other potential benefits that they may enjoy. Because DSTs are fractional investments, they can be more flexibly distributed to your heirs. A single shopping center, multifamily unit, or warehouse can be complicated for heirs to divide, especially if there are disagreements about what should be done with the property. A DST, on the other hand, can be divided among your heirs without the sale of the investment, allowing each heir to make independent decisions about their inheritance more simply.

    A DST is also particularly attractive as an inheritance for younger family members, or those who lack the time, expertise, or inclination to personally manage properties. DSTs offer turnkey professional management,and do not require owners to directly manage properties. With a DST, you can provide your heirs with the potential for monthly income without the headaches of direct property management.

      5. DSTs offer diversification

      Real estate investors understand the importance of a diversified portfolio. If you’re investing in only one property, you’ll immediately feel the impact of any changes to its resale value or rental income. Spreading investments across many properties of various types and geographic locations can be an effective way for investors to prepare for the inevitable risks that come with investing.

      A Delaware Statutory Trust offers investors a straightforward way to diversify. A DST is a pooled investment that can allow qualified investors to own fractions of many different properties. Through a DST, you can access the benefits of a portfolio that includes a range of types and locations of properties.

      For example: if an investor had $1 million to invest in a 1031 Exchange, it would be a challenge to identify and acquire multiple properties of different types and locations for that price — might even be a challenge to find one suitable property. $1million invested in a DST made up of multiple properties will give an investor beneficial interest in those properties. DST investments are subject to investment minimums, but it is possible to invest in multiple DSTs through a 1031 Exchange, creating another opportunity for diversification.

      Is a DST right for my 1031 Exchange?

      No investment option is going to be right for all investors, and every investment comes with risk. Whether a DST is a good option for you will depend on your unique situation. Talk with an advisor or broker to find out if a DST is the right fit for your 1031 Exchange.

      Interested in Learning More About DSTs? Request a Consult.

      Securities Offered through Cabin Securities, Inc. Member FINRA/SIPC. There are material risks associated with investing in DST properties and real estate securities including liquidity, tenant vacancies, general market conditions and competition, lack of operating history, interest rate risks, the risk of new supply coming to market and softening rental rates, general risks of owning/operating commercial and multifamily properties, short term leases associated with multi-family properties, financing risks, potential adverse tax consequences, general economic risks, development risks, long hold periods, and potential loss of the entire investment principal. Past performance is not a guarantee of future results. Potential cash flow, returns and appreciation are not guaranteed. IRC Section 1031 is a complex tax concept; consult your legal or tax professional regarding the specifics of your particular situation.

      This is not a solicitation or an offer to sell any securities. DST 1031 properties are only available to accredited investors (typically have a $1 million net worth excluding primary residence or $200,000 income individually/$300,000 jointly for the last three years) and accredited entities only. If you are unsure if you are an accredited investor and/or an accredited entity please verify with your CPA and Attorney. Because investor situations and objectives vary, this information is not intended to indicate suitability for any particular investor.

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