Delaware Statutory Trust (DST) for 1031 Exchanges Explained

This structure is not considered often enough, and it’s mostly because it’s not explained enough. A Delaware Statutory trust is one of the best fallback options real estate investors never consider.

What a DST Actually Is (and Isn’t)

A Delaware Statutory Trust (DST) is a legal entity, specifically a trust under Delaware law, that holds title to real property. It is set up as a ‘passive’ entity that owns large institutional real estate. A common DST that many investors explore is Amazon warehouses, for example.

It is effectively set up in such a way that allows many fractional investors to invest in a single property. It is similar to a Tenants in Common (TIC), but it is not precisely in the same way. It does not have the same requirements that a TIC does, but it does force all investors to be passive.

Revenue Ruling 2004-86 is where the IRS blessed DST interests as qualifying replacement property. And over the past 22 years, this has allowed investors to defer their real estate gains into fractional shares of much larger properties.

You are effectively viewed as ‘exchanging’ into a direct interest in real estate, because the DST winds up being viewed as a ‘grantor’ trust, which means you, the investor, are viewed as a direct owner.

Benefits of Using a 1031 + DST

Scenario-first. Two common paths:

Path 1: An investor is tired of managing his property and has seen their cash flow reduce over time. They would like to finally go hands-off and get ‘mailbox money’. The DST investment structure is one of the easier options for making this investment and deferring 15 years of appreciation and equity growth.

Path 2: The 1031 Scramble. Sometimes, investors don’t plan as far ahead as they should when selling a property. They get set up with the QI, sell the property… and don’t plan their properties in advance. Now, they need 2nd or 3rd option to consider their 1031. This is a great opportunity where a DST could come into play.

The issue is that DSTs are a lengthy time commitment as well. If an investor is looking for a long-term hold, this can still be appealing.

The Mechanics

This is a step-by-step walk-through of how a 1031 works ultimately:

1. Sell relinquished property: proceeds go to Qualified Intermediary (QI)
2. 45-day identification window: identify DST interests as replacement property (can use the 200% rule or 3-property rule and DSTs count as individual properties)
3. 180-day closing window: QI sends exchange funds to DST sponsor
4. Investor receives beneficial interest in the trust
5. §1031 gain deferred: basis carries over into DST interest
6. Sidenote: Investors are also forced to recognize any depreciation recapture in this instance. It is possible to defer depreciation recapture after having accomplished a cost segregation study, but it is impossible to do so in an exchange with a DST.

The reason for this is that either: a. The property is not similar, or b. There will never be a cost segregation study done on the DST that tells you your recapture amount.

With a 1031-DST Exchange, there are key mechanics that you must consider.

If the DST interest doesn’t absorb the full exchange amount, the remainder is taxable.
This means, if you wind up taking cash out of the deal, or the DST only absorbs a part of your sales price, the remaining ‘cash’ is considered ‘boot’ and is completely taxable.

There is ‘cash boot’ where a real estate investor doesn’t purchase enough assets, or winds up receiving a portion of the sales proceeds directly.

There is also a term called ‘debt boot’ which means an investor either doesn’t borrow the same amount of existing debt, or contribute enough cash to cover the debt. Essentially, the best situation is to always go up in value in a 1031, never down. Especially in a DST exchange.

There are even traps in § 1031s that don’t get considered.

What the DST Can’t Do

While DSTs are great fallbacks, or even preferred options, it has relatively strict requirements. What the IRS lays out in Rev. Rul. 2004-86 imposes strict limitations on DST operations.

The trust CANNOT:

1. Accept additional capital contributions after close
2. Renegotiate existing loans or borrow new funds
3. Reinvest proceeds from the sale of assets
4. Make more than minor non-structural modifications to property
5. Enter new leases (other than pre-existing master lease renewals)
6. Accept cash from operations other than reserves already established
7. Hold anything other than passive investment real estate

These create significant risk to the DST. If the property needs a new roof, operating cash must be used, not a new loan. Anchor tenant leaves? Harder to find new tenants. Where normally a single landlord can pivot and operate quickly, DSTs, due to these limitations, have more difficult movement structure.

This also requires more cash to be kept in the actual investment itself.

When a DST 1031 Makes Sense and When It Doesn’t

When do DSTs & 1031s make sense?

• Investor genuinely wants passive, hands-off real estate exposure. This is an easy case where this type of investment makes sense (just remember that there will not be any true ‘active tax benefits’).
• Also, when an investor is willing to work with a CPA or tax pro on the tax planning and calculation.
  • Why? It is imperative to know whether or not the actual DST offering will match the gain and sales price of the property the investor is selling. If investment amount is too low, then this will cause a portion of your gain to be taxable, which we laid out earlier.
• Another item to consider, for most real real estate investors, this will be the most illiquid investment they might have ever had, and also, the least amount of control. Investors who need control are probably not good fits for DST investments.
• Also, this should go without saying, but an investor should review the DST offerings and agreements included. This will include a review of when cash is expected to be distributed, when the projected sale date is, and what targets are necessary to hit. Looking into the sponsor track record, and the property fundamentals is also important. If an investor is only considering the tax effects of the deal, they are not looking deep enough into and are more likely to make a bad deal.

When a 1031 DST Combo Doesn’t Make Sense?

• Investors who default to DSTs because they are struggling to find property to defer into. If you want liquidity or flexibility, DSTs is one of the least flexible options to use.
• Also, it is incredibly important to take into account additional fees necessary to run a DST. Management fees, extra vendors, there are a lot of associated costs that are involved when it comes to DSTs.
• Also, understanding that when the DST does decide to sell, that means the deferred gain will finally be realized. The necessary planning for this event, if either doing another 1031, or another tax strategy, is rather important.
• Anyone rushing to make this decision should not invest into a DST, as they are not traditional real estate investments.

The Exit: What Happens When the DST Sells

This is the part DST sponsors underemphasize:

Let’s break down how the actual DST exit works. Generally, after the DST has been operating for 5-10 years, now the investors are paid our their percentage of ownership in proceeds. When this sale event happens, all the deferred gain is finally realized. All of it.

Again, having someone in your corner for tax planning is the biggest asset. Because real estate investors should know what their projected gain is, the potential tax due, and this will create the conversation if the investor SHOULD do another DST, or it is time to pay the cost of tax due.

It is possible to go into another DST, but will require coordination with the DST sponsor. Another option that is offered at times is a ‘UPREIT’ structure. The property is contributed to a REIT (real estate investment trust) and is another tax-free exchange. REITs have even less flexibility than DSTs, and investors now own ‘stock’ in a much larger operating entity.

If someone passes away while holding a DST, then the ‘swap till you drop’ strategy has been achieved. This means that original 1031 gain is erased for anyone who inherits the interest, and they can now sell the asset tax free. There are always timing considerations, but this allows generation wealth to be created and considered.

DSTs are not necessarily traditional, and don’t work in every situation, but, should be more often considered by real estate investors.

A DST 1031 is a real tool with real applications, but it’s a planning conversation, not a last-minute scramble. The deferral is only valuable if the replacement investment makes economic sense independent of the tax benefit.

Bottom Line

If the only reason you’re buying a DST is to avoid writing a check to the IRS, you need to slow down and run the numbers. Work with a qualified tax strategist to evaluate your options, model the outcomes, and make a decision that protects both your cash flow and your wealth.