How to Choose Between a DST and a Traditional 1031 Exchange
The pros and cons of Delaware Statutory Trusts when compared to whole properties as 1031 replacement properties.
For more than a century, property owners have been able to defer taxes on the sale of business or investment property through IRC Section 1031 like-kind exchanges. 1031 exchanges rely on the acquisition of “like-kind” property, using a broad definition of that term. Traditionally, this has meant the exchange of individual properties held through a variety of ownership structures.
In 2004, the IRS issued Revenue Ruling 2004-86, allowing for beneficial interests in Delaware Statutory Trusts to be treated as replacement properties under Section 1031. This means fractional interests in DSTs can function as like-kind properties in 1031 exchanges, allowing exchangers to go from directly-owned property to DST and vice-versa.
For 1031 investors who only have experience with direct property ownership, the benefits of a DST might not be obvious, but for some exchangers, choosing a DST as a replacement property is the right move. Understanding the pros and cons of these two kinds of 1031 exchange replacement properties can help you make a more informed decision.
Simplicity, diversification, and passive income: why exchangers are increasingly looking to DSTs
Delaware Statutory Trusts, in which up to 499 investors pool their capital to invest in a property or properties managed by a professional property manager, have several advantages as 1031 replacement properties, with the most obvious being diversification.
There are many types of DSTs, some of which own a single property and others that own a series of properties. A multi-property DST provides instant diversification for investors, as well as access to new markets and institutional-quality real estate they may not otherwise have access to. What’s more, the cost of entry can be lower: many DSTs have a low minimum investment amount, meaning the proceeds from a single property sale can be exchanged into multiple DSTs. Going from a single property of one type in one market to a series of DSTs, each targeting different property types and markets, is a big leap in portfolio diversification.
This diversification can be helpful in maintaining portfolio value in uncertain times. While a lone property can increase or decrease in value depending on the market, DSTs are seen as a smart hedge against inflation because they invest in sectors that have historically thrived in down economies.
Another major benefit of DSTs is passivity. DST investors receive distributions from the rent paid on the DST’s properties, but they don’t have to concern themselves with duties like collecting rent, maintenance, or other tasks that are instead performed by a professional property manager. This makes the income from a DST much more passive than what those who’ve previously owned rental properties may be used to.
Regular distributions can make DSTs an attractive option for retirees. By transitioning from active to passive property management, they can supply themselves with steady income in retirement. And by diversifying with multiple DSTs, estate planning can be simplified: instead of leaving behind a single property to a group of heirs, DST interests can be divided up among inheritors while still receiving a step up in basis.
DSTs also have a reputation for reliability. DST debt is non-recourse, meaning it is taken on by the DST, not its investors, lowering the risk for the individual. The properties have already been vetted by the manager of the DST, and aren’t in danger of falling through in a competitive real estate market, meaning transactions can be closed quickly and have a greater chance of success. Many exchangers use DSTs as a backup option among their identified properties in case a desired replacement property falls through.
Whether you’re looking at a DST as a backup or primary option, these are just a few of the reasons investors use DSTs as replacement properties. However, there are some downsides, and certain investors may find the advantages of direct property ownership outweigh the diversification and passivity of a DST.
Liquidity, control, & exit strategies: why many investors prefer direct ownership
With a directly-owned property, you aren’t giving up your control to a DST manager. That means you can purchase the exact property you want. With a DST, the portfolio properties have already been selected. If there are three properties in the DST and you only like the prospects of two, you can’t choose to invest solely in the two you like – it’s all or nothing.
The control of direct property ownership also means you can choose the tenant and rent terms, as well as how the property is managed. Actively managing a property requires work, but for some investors, this can be a good thing, especially when it comes time to sell.
DSTs have a set holding period, and don’t sell their assets until this holding period is up, even if real estate prices go way up. With a directly-owned property, you can take advantage of fluctuations in the market, but with a DST, you can only exit early by selling your interest in the DST. A DST interest is transferrable, but may be more difficult to sell than a whole property. If you can’t find a buyer, you’ll have no choice but to retain it for the entire holding period.
That said, when the holding period ends, the DST manager may provide a new DST that you can exchange into, making subsequent 1031 exchanges simpler. This is a plus for those who want simplicity, but for those who crave control, it may not be much of a benefit. There is also the possibility of a 721 upREIT exchange, in which an exchanger can go from a DST to a REIT, further increasing their diversification. This option isn’t for everyone, but it should be noted that for investors who want to defer taxes and move from a directly-owned property to REIT shares, there is a way to do so.
It’s also important to note that DSTs charge fees in order to pay property managers, and if you fail to understand those fees, your returns may be lower than you expect. What you’re paying for is diversification, institutional-quality real estate, and passive income while sacrificing control and flexibility. If that seems like an easy choice, then you already know which one you want to pursue. If you’re still unsure, there are other options like triple-net leases or Plotify Plots that are more passive than traditional property acquisitions but allow for greater control than DSTs. No matter what you choose, it’s important to make sure you take full advantage of the tax deferral allowed by Section 1031.
How JTC can help
Delaware Statutory Trusts can qualify as replacement properties in a 1031 exchange, but if you’re exchanging into multiple DSTs, calculating the necessary debt ratio and investment amounts to achieve full tax deferral can be complicated. You should always work with a Qualified Intermediary that understands these types of exchanges and can ensure funds are handled properly, no matter how many properties or DSTs are involved.
JTC’s 1031 exchange team has decades of experience in 1031, with specific expertise in the most complicated types of exchanges, including those involving Delaware Statutory Trusts. We provide full transparency and security measures to help our clients ensure that even when they’re exchanging into a new property type, they receive the same institutional-quality technology and support they need for 1031 success.
To learn more about JTC’s 1031 exchange services, click here.
