Delaware Statutory Trusts and 1031 Exchanges

Are you a real estate investor looking to build your wealth through investments while minimizing your tax liability? If so, then Delaware Statutory Trusts (DSTs) and 1031 Exchanges are two powerful tools to be incorporated into your portfolio.

Overview of 1031 Exchanges

A 1031 exchange (26 U.S.C. § 1031), also known as a “starker” exchange, is a powerful wealth building mechanism that allows an owner of investment property to defer paying capital gains taxes resulting from the sale of property, freeing up funds for reinvestment to maximize the overall return on investment.

Deferring capital gains tax can be achieved by “exchanging” the “Relinquished Property” (i.e., the sold property) for “Replacement Property “of like kind.” The proceeds from the Relinquished Property sale must be held during the exchange period by a “Qualified Intermediary” and must be used to purchase the “Replacement Property” within 180 days from the sale date of the Relinquished Property. The investor must also identify “Replacement Property” within 45 days from the sale date of the Relinquished Property. Failure to identify Replacement Property within 45 days and or purchasing the Replacement Property within 180 days will result in a failed 1031 exchange.  

To qualify for a 1031 exchange, the Relinquished Property must be held for investment, trade, or business. Likewise, the Replacement Property must be “like kind” to the Relinquished Property and intended to be held for investment, trade, or business.

Overview of Delaware Statutory Authority Trusts in 1031 Exchanges

Delaware Statutory Trusts (DSTs) are a widely used ownership structure for holding title to real estate assets. DSTs come in various forms and offer different investment opportunities. There are DSTs focused on residential, commercial, and/or industrial properties, specific geographic areas, or property classes.

REITS vs DST

On the surface, REITs and DSTs appear similar; however, a deeper dive highlights many key differences. REITs are companies that own, operate, or finance income-generating real estate including offices, apartments, shopping centers, hotels, and more. Most REITs are publicly traded and enable investors to earn dividends from real estate without having to buy individual properties but rather a “stock” share in the REIT.

Unlike DSTs, publicly traded REITs provide liquidity for investors. Perhaps the most important distinction between a REIT and a DST is that REITs cannot be used in 1031 exchanges since investors own share(s) of the REIT.

How DSTs and 1031 Exchanges Work Together

In a 1031 exchange involving a DST, the investor sells their Relinquished Property, the proceeds from the sale are directed to a Qualified Intermediary, who holds the funds during the “Exchange Period.” Thereafter during the 45-day identification period, the investor identifies the Replacement Property, including the specific DST investment, and any other property the investor may contemplate purchasing with the Exchange proceeds.  To finalize the exchange investor must purchase the Replacement Property with Exchange proceeds within the 180-day exchange time period. 

There are many benefits to the DST structure which make it an increasingly popular 1031 exchange target property for investors. DSTs are a passive investment allowing investors to hold a beneficial ownership interest in large commercial grade properties while simultaneously not assuming any direct management responsibility. Using a 1031 exchange to obtain a DST allows investors to achieve a level of diversification not necessarily achievable from single property ownership. A diversified portfolio that provides completely passive income is an investor’s dream. They are also pre-packaged for 1031 exchanges, so an investor can close on a property extremely fast. As mentioned, 1031 exchanges have extremely tight timelines, so a rapid turn-around is something investors require. Lastly, the financing typically used for the properties held is non-recourse. In the case of a default, the lender can only pursue the subject property, leaving the investor’s other assets protected from legal recourse.

Structuring Your Holdings

As for all types of investments, investors must do their due diligence prior to investing in Delaware Statutory Trusts (DSTs) and 1031 Exchanges.  Investors should also be mindful of how best to hold title to their various investments to protect themselves and to consider best practices in transferring wealth to current and future generations.

The experienced Estate Planning, Real Estate, and Tax attorneys at RJS LAW are available to discuss the many options available to individual investors. Proper upfront planning and/or a review of existing holdings provides investors the peace of mind to know their financial holdings will serve them and their heirs well into the future. Please call RJS LAW at 619-595-1655 or contact us on the web at RJS LAW for a no-cost consultation.   

Written by Sean Erdman