Why We Love DSTs As a Tax Deferral Solution
In the past few years real estate investors in competitive markets have seen some of the highest sale prices in history. As a result, many have decided to cash out now and reinvest their sales proceeds using a 1031 Exchange into what is hopefully a better opportunity at a lower price. In other words, they want to sell high and buy low.
But therein lies the problem. The reality is not all investors will find a replacement property at an attractive price in the same market where they are currently commanding high prices on their property sales. Not to mention keeping the process within the time frame required of 1031 Exchanges.
We often see clients enter the exchange process with the intent of sourcing property within their allotted 45-day identification period. Then, upon finding the market is highly competitive with limited inventory, they are confronted with the challenge of identifying a replacement property before their time runs out. Do they forgo a 1031 Exchange and simply pay the capital gains tax on their property sale? Or purchase a property of potentially lower quality at a price substantially different than the value of their relinquished property, ensuring they either pay tax on the "boot", or inject more cash into the deal? And given the current state of interest rates, it’s exceedingly difficult to coordinate and qualify for advance financing when leverage is needed.
To assist our clients in overcoming the challenges of finding the perfect replacement property, we generally use the Delaware Statutory Trust (DST) investment option as an ideal tax-deferred solution for a 1031 Exchange.1 There are a host of reasons why DSTs are beneficial to 1031 Exchange investors, including:
- DSTs qualify as "like-kind" replacement properties under IRS guidelines
- The trusts already own properties, helping to meet exchange deadlines
- Properties are institutional quality and professionally managed, often with investment-grade credit
- Fractional ownership gives average investors access to properties they otherwise may not have been able to invest in
- DST portfolios may own multiple properties, providing diversification across property and tenant types as well as location
- Debt is considered non-recourse to investors; debt helps increase the value of an investor’s real estate portfolio, oftentimes providing the tax benefit of a depreciation deduction and increasing net after-tax income
- Historically a source of low risk, reliable income; quality tenants are unlikely to default or file for bankruptcy
- The closing process is relatively simple, quick and can be done completely electronically; it avoids last-minute 180-day deadline issues
- Issues with boot are eliminated; there are many options to choose from to place any “leftover” proceeds into, thereby avoiding boot
- Usage as a wealth transfer tool; fractional ownership allows for flexible distribution of assets to beneficiaries; heirs receive a stepped-up cost basis, eliminating the capital gains tax
If you are currently considering a 1031 Exchange, we encourage you to look closely at the DST investment option. Our Tax Deferred Strategies for Real Estate Brochure provides an in-depth view of why we love DSTs and often recommend them to our clients.
As an effective tax-deferred investment strategy compliant with IRS’ 1031 Exchange guidelines, a DST may be your path to reinvesting your sale proceeds in a superior replacement property.
1. The Delaware Statutory Trust, or DST, is a legally recognized entity that is established as a trust under the laws of the state of Delaware and qualifies as replacement property for accredited investors under Section 1031 as a tax-deferred exchange. A DST can hold title to one or more income-producing commercial properties of any type; apartments, retail space, office buildings, industrial parks, etc. Each investor owns a “beneficial interest” in the trust which, in turn, owns the underlying Real Property. This DST interest entitles the investor to his or her pro-rata share of income and appreciation in the DST’s assets.