Understanding Delaware Statutory Trusts (DSTs)
A Delaware Statutory Trust (DST) is a legal entity used to hold investment properties, allowing multiple investors to pool funds and acquire fractional ownership interests. DSTs facilitate tax deferral under Section 1031 of the Internal Revenue Code, enabling investors to exchange real property for interests in professionally managed, institutional-grade assets while deferring capital gains taxes.
- Tax Deferral via 1031 Exchange: Allows for deferring capital gains tax on the sale of investment properties.
- Passive Income Stream: Provides consistent income without active management responsibilities.
- Diversification of Investment: Offers the opportunity to invest in a variety of property types and locations.
- Lower Minimum Investment: More accessible entry point compared to direct commercial property ownership.
- Reduced Management Hassles: Eliminates the need for direct involvement in property management and maintenance.
For investors in Delaware Statutory Trust properties, planning an exit strategy is a crucial component of their long-term investment approach. While DST investments are typically held for approximately five to ten years, the process can vary depending on market conditions and specific circumstances. Once the investment reaches the end of its life cycle, known as “going full-cycle,” investors need to determine their next steps.
When a DST investment goes full-cycle, investors are faced with several choices regarding how to move forward. The three most common exit strategies include: cashing out, initiating a 1031 Exchange into another like-kind property, or taking advantage of a 721 UPREIT exchange. Each of these options comes with its own benefits and considerations, which we will explore below.
One of the simplest exit strategies is to cash out once the DST goes full-cycle. This means selling the investment and receiving your share of the proceeds. While this may seem straightforward, investors should be prepared for potential tax implications. By choosing to cash out, they may be subject to various tax liabilities, such as:
- Federal capital gains tax
- State capital gains tax
- Depreciation recapture tax
- Medicare surtax
For some investors, cashing out could result in a significant taxable event, which might reduce their overall net return. Additionally, cashing out eliminates the opportunity to continue deferring taxes through a 1031 exchange or other tax-efficient strategies.
A popular exit strategy for DST investors is a 1031 Exchange, also known as a like-kind exchange. This IRS-approved process allows investors to defer the capital gains tax on the sale of a DST property by reinvesting the proceeds into another qualifying like-kind property.
Many investors choose to engage in a series of 1031 exchanges, continually deferring capital gains taxes until the assets are passed on to their heirs. At that point, the DST can be transferred with a step-up in basis, effectively resetting the value of the property for tax purposes and potentially eliminating the deferred tax liability.
To qualify for a 1031 exchange, investors adhere to specific guidelines:
- Reinvest the proceeds into a property of equal or greater value
- Using a qualified intermediary to handle the transaction
- Completing the exchange within 180 days of closing on the original property
While this strategy allows investors to continue building wealth in real estate, it also locks in the capital, making it inaccessible for other opportunities. Additionally, the process can be complex and requires careful planning to ensure compliance with IRS regulations.
The third potential exit strategy is a 721 UPREIT Exchange, which allows investors to convert their real estate holdings into Operating Partnership units within a Real Estate Investment Trust (REIT). This option, under Section 721 of the Internal Revenue Code, enables investors to contribute their property to a REIT in exchange for partnership units on a tax-deferred basis.
Here’s how it works: After a DST property goes full-cycle, a REIT may purchase the real estate. Investors can then contribute their DST interests in exchange for OP units within the REIT. These units can eventually be converted into REIT shares, providing liquidity in a taxable transaction or held indefinitely, depending on the investor’s preference.
One of the primary benefits of a 721 UPREIT exchange is its potential for estate planning. OP units can be divided and transferred to heirs with a step-up in basis, thereby eliminating the deferred tax liability. However, once an investor proceeds with a 721 exchange, they lose the ability to continue deferring taxes through a 1031 exchange. The only remaining option for liquidity is to convert OP units into REIT shares, which triggers a taxable event.
When a DST investment goes full-cycle, investors need to evaluate all available options based on their financial goals, tax considerations, and long-term strategies. While cashing out offers immediate access to funds, it may lead to substantial tax liabilities. A 1031 exchange allows for continued tax deferral and wealth building but ties up capital in real estate. Meanwhile, a 721 UPREIT exchange offers a path to liquidity and estate planning benefits, yet limits further tax deferral opportunities.