In the investing world, knowledge is power. Having a deep understanding of what you’re investing in and why won’t eliminate all risk, but it will help you feel confident in the decisions you make about your investments.
As powerful as knowledge is, it can be difficult to obtain — especially when it comes to seemingly complex investments like Delaware statutory trusts, also known as DSTs. Even investors who are familiar with DSTs may not understand everything about this unique form of real estate investment.
In this article, we’ll explore the history and structure of DSTs and provide insight into what makes it an attractive investment for some investors.
What is a Delaware Statutory Trust?
A Delaware statutory trust, also known as a DST, is a unique real estate investment vehicle that allows a group of individual investors to purchase fractional interest in a large commercial real estate asset. This asset can be one property or a portfolio of multiple properties. These properties are often valued at a price that would not be accessible to any of the individual investors if they were to invest alone.
A DST is created by a DST sponsor. DST sponsors acquire the real estate assets for a DST. They also establish a trust which holds the property or properties they’ve acquired. As individuals invest in a DST, their investments displace the capital used by the DST sponsor to acquire the properties.
Investors in a DST hold beneficial interest in the trust that holds their investment. This can be understood as a “fractional” investment in the real estate held by the DST, since each investment in the DST is at a price that is a fraction of the total cost of the property or properties held by the DST.
Beneficial interest entitles investors to a share of any income or loss of income, as well as any appreciation or loss of value that the DST generates. Investors can also receive a share of any income tax shelters associated with the property held in the DST. The share investors receive through beneficial interest in the DST is pro-rata, meaning the size of an investor’s beneficial interest is proportional to how much they invest.
A DST will have a limit on how many investors can invest in the DST, which will not be greater than 499 investors. Subject to minimums, investors can choose how much or how little they will invest in a DST.
History of DSTs
While the concept of a trust dates back to at least 16th century England, the DST investment structure was recognized in Delaware common law in 1947 and was formalized into Delaware law in 1988 with the Delaware statutory trust Act.
Delaware statutory trusts have increasingly been in a variety of contexts for the purposes of asset protection, tax deferral, and balance sheet advantages. In 2004, the IRS issued a ruling which classified DSTs which hold title to property as “like kind” property for the purpose of a 1031 Exchange. This change has led to DSTs increasingly being used in combination with 1031 Exchanges, offering investors an alternative way to benefit from management free real estate investment while still potentially deferring up to 100% of property taxes that would otherwise be realized in the sale of an investment property.
DST Pros and Cons
The unique structure of a DST makes it a more or less attractive option to different investors. If you’re interested in investing in a DST, understanding the risks and potential benefits will help you decide if a DST is something you would like to invest in.
The structure of DSTs as a fractional investment in real estate offers investors some unique potential benefits, including:
Diversification: When you diversify your investments across multiple assets, you can make it less likely that a single negative event will affect your entire portfolio equally. Diversification is an important risk management tactic, and one that can be difficult to achieve when you invest in a single property. Subject to investment minimums, investors can exchange one property into a DST that holds title to a portfolio of multiple properties. This has the potential to offer diversification of asset type and geographical location to investors.
Passive Real Estate Ownership: DSTs are professionally managed by DST sponsors or another party designated to manage property. Investors in DSTs do not have to actively manage properties or tenants, making a DST a more passive way to invest in real estate.
Institutional Grade Properties: Institutional grade properties are high-quality, high-value properties or portfolios of properties which are typically only available to institutional investors, like pension funds, insurance companies, and endowment funds. When a DST holds institutional-grade properties, they can be made accessible to a wider range of investors, since a DST makes it possible to invest at a price lower than the purchase price for the entire property.
DSTs also come with risks and qualities that some investors see as drawbacks. These factors can include:
Limited Control: While DSTs do offer a more passive way to invest in real estate, this also means investors have less input into how the properties they invest in through a DST are managed. Beneficial owners possess limited control and rights over the DST they invest in. The trust controlling the DST will operate and manage the investment, and beneficial owners may not participate in the management of the trust.
Real Estate Investment Risks: DST interests are direct investments in real estate. They are subject to all the risks of real estate investment. This includes, but is not limited to, exposure to cyclical economic shifts affecting real estate.
Limited Liquidity: DST investments are considered illiquid. There is currently no established secondary market for the resale of DST interests. This tends to make DSTs more attractive to investors who have access to liquidity through other means, and who want to prioritize other factors with a DST investment.
There are more risks and potential benefits to a DST investment than what we’ve outlined above. A broker or financial advisor can help you to completely understand all the risks and potential benefits, as well as any information specific to the particular DSTs you might be interested in investing in.
Delaware Statutory Trust and 1031 Exchange — How Do They Work Together?
1031 Exchanges allow property owners to defer taxes on capital gains by exchanging their appreciated real estate for another like-kind property instead of selling for cash and realizing capital gains. Because they’re considered like-kind property, DSTs can be a part of your 1031 Exchange. When it comes time to sell your DST, you can execute another exchange out of your first DST and into another. This is how it works:
- When you decide to execute your exchange, you can choose to exchange your owned property for any like kind-property, including a DST. Most properties held for investment purposes or business uses are considered like-kind and are eligible for a 1031 Exchange.
- When an owned investment property is exchanged for a DST, capital gains taxes are not realized. When it’s time to sell, another 1031 Exchange can be executed, and capital gains taxes will continue to be deferred.
- With some strategic planning, for some investors, conducting multiple 1031 Exchanges can have benefits for heirs who inherit an exchanged property. If exchanged property is held until the investor’s death, and it is exchanged multiple times, the tax liability on the property can be avoided or reduced for the investor. Heirs will then inherit the property with a “stepped-up” tax basis: this means that the taxes will be based on the market value at the time of inheritance, rather than the value of the property when the original investor purchased the exchanged property. This can reduce the tax burden that heirs are left with.
Delaware Statutory Trust Investments — Right for Every Investor?
There is no perfect investment for every investor. If you’re curious about a Delaware statutory trust and want to understand how you can invest in one, reach out to an expert. A financial advisor or broker who is experienced with DSTs can help you understand your DST investment options, and assure that you make an investment choice you feel confident in.
