A 1031 Exchange Delaware Statutory Trust, sometimes known as a DST, is a legal structure used to postpone paying capital gains tax on proceeds from the sale of a rental property into a real estate portfolio. Similar to a TIC or tenant in common, a 1031 Exchange Delaware Statutory Trust can invest a portion of its assets in real estate; but, unlike a TIC, a DST 1031 property will be eligible to serve as a “like-kind” exchange replacement property for a 1031 exchange. This “like type” property designation is made in accordance with Internal Revenue Code Section 2004-86.
Although a 1031 Exchange DST business can be utilized to hold title to a wide range of assets, a triple net (NNN) leased commercial or office facility or multifamily residential properties are traditional DST 1031 exchange properties. In a triple net leased property, the tenant is often in charge of paying the property taxes, maintenance fees, and insurance.
We hope that my brief explanation of a 1031 exchange DST has been helpful. Give us a call at 00-240-9094 to learn more about 1031 exchanges!
What is a 1031 Exchange?
A 1031 exchange is a transaction that lets you exchange a real estate investment property for another while deferring capital gains taxes. Real estate brokers, title firms, investors, and soccer moms all use the phrase, which originally comes from Section 1031 of the Internal Revenue Code (IRC).
Property investors have to understand IRC Section 1031’s complex workings before attempting to exploit it. Internal Revenue Service (IRS) regulations restrict the use of exchange to like-kind properties only and prohibit it from being used for vacation properties. Additionally, there may be issues with time constraints and tax ramifications.
DSTs – An Intriguing Armchair Investment for 1031
In today’s 1031 exchange market, the Delaware Statutory Trusts (DSTs) are an intriguing option that can be a convenient and attractive alternative to traditional passive management. The following three potential benefits of Delaware Statutory Trusts can help you understand their potential.
The Delaware Statutory Trusts and 1031 Exchanges programs were designed with three primary goals in mind:
- To provide an effective and timely solution to a problem faced by many real estate investors;
- to provide an effective solution that is simple to understand;
- and to offer an effective solution with the lowest possible capital gains tax liability.
What is a Delaware Statutory Trust (DST)?
A legal organization known as a Delaware Statutory Trust (DST) is one that was established by Delaware law as a trust that owns title to the whole interest in real property.
In exchange for their investment, investors receive a limited personal liability benefit interest in the trust. DSTs are distinct from Tenancy in Commons (TICs), a further fractional ownership technique used in 1031 Exchanges, in that each investor does not have an undivided, fractional stake in the property. As a result, DST participants are not obligated to split the ownership expenses or be referred to as “tenants in common.”
What are DST 1031 Exchanges and How Do They Work?
A 1031 exchange is a tax deferral scheme accepted by the IRS that enables an investor to sell a rental property and buy a property that is identical in order to postpone capital gains and depreciation recaptures taxes. Since capital gains taxes were raised in 2013, more investors are anticipated to look for a tax-deferred option when selling real estate.
Investors have the option of buying a full property or partial ownership in a 1031 exchange. One advantage of fractional ownership interests in commercial real estate assets that might be an appealing alternative to a wholly-owned property is the possibility to close within the short 180-day time restriction and take passive possession (investors not actively operating the property).
Step 1: (Also known as Day 0: Close of Property) The investor signs a contract with a licensed middleman who arranges a property transaction.
Step 2: (Day 45: Identification Period) The owner sells the property that has been given up to a different buyer.
Step 3: The qualified intermediary receives the sale money.
Step 4: Within the time frames specified by the Internal Revenue Code, the qualified intermediary utilizes the money to buy the replacement asset on behalf of the investor.
Step 5: (180 Days: Maximum Time to Complete) After the transaction is complete, the investor either acquires the replacement property outright or a portion of a trust that does.
What Are a Few 1031 Exchange DST Properties?
Multifamily apartment complexes, shopping malls, self-storage facilities, or medical offices are some more DST 1031 exchange property types that have been accessible to investors. Long-term leasing agreements are customary for these buildings with renters. Many properties are offered to our eligible, accredited clients with our 1031 exchange DST portfolios, with a usual minimum capital investment of $25,000.
To meet an investor’s exchange criteria of taking on “equal or higher debt,” as stated by Internal Revenue Code Section 1031, DST 1031 exchange assets also have a variety of financing ratios. To reduce the danger of utilizing loans to buy homes, certain DST 1031 exchange assets are available for all-cash, debt-free transactions. On DST 1031 properties, the financing is frequently non-recourse to the buyer. Generally speaking, non-recourse financing is credit where the lender’s only recourse in the event of a default is the target asset itself. Beyond the relevant property, the lender is not permitted to pursue the investor’s other assets.
Therefore, in the event of a significant tenant bankruptcy, a market-wide recession, or depression, investors may lose their whole main investment in the property, but their other properties would be safe from the lender.
What Is A 1031 Exchange DST In Terms Of Financing?
The non-recourse financing utilized for DST 1031 exchange properties is often long-term (about seven to 20 years) and already in place with the lender. For buyers that must be able to find an estate within the 45-day identification period which they know they will be able to close on, this can significantly help to decrease the 1031 exchange DST closure risk. A DST 1031 exchange property typically has a loan-to-cost ratio of between 40 and 65 percent.
A DST 1031 exchange asset with a 50% mortgage to cost is one where the investors contribute 50% of the necessary equity or cash to buy the 1031 exchange DST asset and the lender provides the remaining 50% in the form of a loan. Owners of DST 1031 exchange properties often receive 100% of their pro-rata share of any possible principal pay-down from the real estate loan, enabling the investor to increase the value of the asset.
It’s crucial to understand that some DST 1031 exchange properties have loan structures with principal pay-downs starting in the first year, some with principal pay-downs starting in years two through five, and yet others with loan structures with interest-only financing. DST 1031 exchange homes are designed such that the prices reflect 100% of the pro-rata share of any prospective rental revenue that the property’s tenants could earn. Investors in 1031 exchange DSTs are entitled to 100% of the pro-rata share of any prospective net profit of the property throughout the investment horizon.
In this regard, DST 1031 properties actually differ from tenants in ordinary agreements. The offering sponsor is often entitled to a percentage of the possible rental revenue and future property appreciation under a tenant in common.
Benefits & Risks of DST investments
Just like any other investment, DST investments can have risks and benefits in return.
Prospective Benefits of DSTs
DSTs have grown in popularity for carrying out 1031 exchanges due to the variety of benefits of ownership under trusts. Below are a few possible advantages:
Investors with debt at the property level have no recourse for personal loans.
- Smaller down payment required.
- Diversification across many properties is possible.
- Many alternative strategies which are more versatile.
Prospective Risks of DSTs
Investors ought to be aware of a number of possible hazards connected to DST exchange schemes in addition to the advantages. Above are a few possible dangers:
Limited transferability, low liquidity, and little influence on management choices for private investors.
Investor income may become instantly taxable if the trustee breaks one of the statutory tax limits.
The tax deferral might suffer if the tax code changes.
DST 1031 exchanges can be a great way to defer capital gains taxes on the sale of an investment property, but there are some things investors should keep in mind before investing in a DST. We’ve outlined some of the benefits and risks associated with these investments, so if you’re considering a 1031 exchange DST, please contact us for more information.