Recently we met an investor named Mark, who had sold an apartment complex after completing a successful value-add strategy on the building. All the hard work had paid off, and he had a strong buyer lined up. The only problem was the dramatic haircut he’d take from taxes owed if he sold and simply pocketed the cash.
Inventory in multifamily apartment properties is about a third of what it was on average from 2018 to 2022. That means for anyone who needs or wants to do a 1031 exchange, the options are becoming increasingly limited.
With historically low inventory in the apartment market, Mark was looking at short-term vacation rentals as the best replacement option for his 1031 exchange, since the housing market has shown more velocity than the apartment market. However, the short-term rental market has reached a point of saturation in many areas that has made the financials less favorable.
Enter the Solution: The Delaware Statutory Trust (DST)
A Delaware Statutory Trust (DST) is a legal entity that allows multiple investors to hold fractional interests in a single property or a portfolio of properties. DSTs have gained popularity as a 1031 exchange vehicle for their flexibility and potential benefits.
Many investors like Mark aren’t familiar with this option because it straddles the fence between a real estate offering and a security. Many real estate brokers aren’t familiar with it either, and some securities professionals may not realize a DST can be used for a 1031 exchange. Because neither side is always well versed in the other, clients can go without ever hearing this suggestion from either of their advisors.
That’s largely because the Securities and Exchange Commission places careful parameters on the sale of participation in syndication funds, and a DST is a type of syndication fund. However, a DST is unique in how title to the property is taken, which allows an investor to complete a 1031 exchange by satisfying the requirement that the replacement property be held in the same name as the property being sold.
Key Advantages of a DST in a 1031 Exchange
- Passive investment: DSTs offer a passive investment structure, letting investors own fractional interests without the responsibilities of property management. That’s often a primary reason sellers pursue a 1031 exchange in the first place, trading a management-heavy property for a more passive investment like a NNN lease property.
- Diversification: DSTs often include larger, institutional-grade properties such as apartment complexes, commercial buildings, or storage facilities. Participating in a DST can give investors access to a diversified portfolio that might otherwise be out of reach.
- Ease of use: DSTs simplify the 1031 exchange process. Investors can identify and close on a replacement property within the IRS’s tight deadlines, reducing the risk of a failed exchange.
- Potential income stream: DSTs typically distribute rental income to investors on a regular basis, providing a reliable income stream that can supplement other investments or serve as passive retirement income.
- Asset protection: Holding properties within a DST can provide a degree of asset protection, shielding individual investors from the liability associated with direct property ownership.
Potential Risks and Considerations
While DSTs offer significant advantages, it’s worth weighing a few risks as well.
- Lack of control: Investors in a DST have limited say over property management decisions and rely on a trustee to make those calls, so it’s crucial to thoroughly vet the trustee and trust structure.
- Illiquidity: DSTs typically have a fixed investment term, making them illiquid. Investors should be prepared for their capital to be tied up for the duration of the trust.
- Limited exit options: Exiting a DST can be challenging, since there’s no secondary market for DST interests. Investors may need to sell their interest privately or wait until the trust’s term expires.
A Delaware Statutory Trust can be a powerful tool for real estate investors looking to maximize the benefits of a 1031 exchange. By offering passive ownership, diversification, and a simplified exchange process, a DST gives investors another way to defer capital gains taxes while optimizing their real estate portfolio.
With this solution in hand, Mark was able to complete his 1031 exchange through a placement sourced from his financial advisor, and now enjoys a more passive strategy as he looks toward retirement. Need a recommendation or have questions about this strategy? We’re always happy to discuss it, and look forward to being your trusted advisor.
