DSTs with Cost Segregation May Enhance Value

There is an inter­est­ing syn­er­gy cre­at­ed when a Delaware Statu­to­ry Trusts (DSTs) that uti­lizes a cost seg­re­ga­tion for a spe­cif­ic prop­er­ty.

June 5, 2024

By Al DiNi­co­la, AIF®, CEPA™
DST 1031 Spe­cial­ist
NAMCOA® — Naples Asset Man­age­ment Com­pa­ny®, LLC
Secu­ri­ties offered through MSC-BD, LLC Mem­ber of FINRA/SIPC

Cou­ple that syn­er­gy with the Tax Cuts and Jobs Act (TCJA) of 2017 and there may be a height­ened inter­est from investors.  How­ev­er, the real estate offer­ing needs to have sol­id fun­da­men­tals. This syn­er­gy may pro­vide enhanced tax ben­e­fits and invest­ment oppor­tu­ni­ties for accred­it­ed investors. Tax strate­gies may be opti­mized using the right forms, for­mu­las and tim­ing.

Delaware Statu­to­ry Trusts (DSTs)

Since 2004 DSTs have been uti­lized by investors to hold real estate inter­est.  Typ­i­cal­ly, DSTs are cre­at­ed by large real estate spon­sors. These enti­ties are pack­aged and offered to accred­it­ed investors. Most investors will seek out the ser­vices of a finan­cial advi­sor who reg­u­lar­ly reviews offer­ings and com­pletes due dili­gence on the offer­ing. The DST is a legal enti­ty cre­at­ed under Delaware law. The struc­ture allows investors to hold ben­e­fi­cial or frac­tion­al inter­ests in com­mer­cial real estate. While direct cash is invest­ed in DSTs many times the DST equi­ty comes from Qual­i­fied Inter­me­di­aries (QI) on behalf of investors uti­liz­ing a 1031 exchange.  The §1031 per­mits investors to defer cap­i­tal gains from the sale of real estate by rein­vest­ing all the pro­ceeds into anoth­er qual­i­fy­ing prop­er­ty.  In addi­tion, if there was a loan sat­is­fied on the sale of the prop­er­ty that loan needs to be replaced as well.

Over­all Ben­e­fits of DSTs:

1. §1031 Exchange Eli­gi­bil­i­ty: The IRS requires like-kind prop­er­ty and DSTs qual­i­fy. This makes DST ide­al for cer­tain investors for an exchange.
2. Pas­sive Own­er­ship: Active man­age­ment comes with respon­si­bil­i­ties. Investors seek­ing a more pas­sive role enjoy the abil­i­ty to invest in large (many times insti­tu­tion­al grade) real estate.  This with­out the headaches of active man­age­ment.
3. Diver­si­fi­ca­tion: DSTs are locat­ed in many geo­graph­ic areas and in many asset or prop­er­ty class­es. Investors may acquire dif­fer­ent geo areas and asset class­es diver­si­fy­ing their port­fo­lio. As a note with all invest­ment diver­si­fi­ca­tions may mit­i­gate risk but not guar­an­teed to elim­i­nate risk.
4. Income Dis­tri­b­u­tion: The struc­ture of the major­i­ty of DSTs is to dis­trib­ute income month­ly from the income gen­er­at­ed from the prop­er­ty. The excep­tion by design would be a Zero-Coupon DST which directs the dis­tri­b­u­tion to retire the struc­ture debt on the prop­er­ty.  Zero DST may pro­vide a high lev­el of pas­sive loss­es.
5. Low Invest­ment Require­ments: Direct own­er­ship of real estate typ­i­cal­ly requires a larg­er invest­ment than DSTs.  DST may accept invest­ment as low as $50,000.  This may be ide­al for exchanges that have left over cash (boot).

Cost Seg­re­ga­tion- poten­tial sav­ings struc­ture

Com­mer­cial prop­er­ty typ­i­cal­ly uses a 27.5 year or 39-year depre­ci­a­tion sched­ule. The IRS allows cer­tain assets to be depre­ci­at­ed using short­er time peri­ods. Name­ly 5, 7, or 15 years. By carv­ing out, or seg­re­gat­ing, the assets with short­er time peri­ods depre­ci­a­tion of those asset may be accel­er­at­ed. Accel­er­at­ed depre­ci­a­tion cre­ates tax defer­ral with increas­es cash flow. A point to remem­ber in cost seg­re­ga­tions depre­ci­a­tion isn’t increas­es, it is accel­er­at­ed. When you fac­tor in the time val­ue of mon­ey this is where the increased cash flow is real­ized. If you envi­sion buck­ets that per­mit a dif­fer­ent sched­ule for each type of prop­er­ty: real prop­er­ty (base build­ing), tan­gi­ble per­son­al prop­er­ty (car­pets, floor­ing, spe­cial­ty plumb­ing, etc.), and land improve­ments (paving, side­walks, shrub­bery, etc.). Land itself is not depre­cia­ble.

Cost Seg­re­ga­tion in DSTs

 Cost seg­re­ga­tion accel­er­ates depre­ci­a­tion by reclas­si­fy­ing cer­tain prop­er­ty com­po­nents into short­er recov­ery peri­ods, which can sig­nif­i­cant­ly reduce tax­able income in the ear­ly years of invest­ment. Not all DST spon­sor will pro­vide a cost seg­re­ga­tion analy­sis or study.  How­ev­er cost seg­re­ga­tions can be applied to DSTs.

Key Pro­vi­sions of the Tax Cuts and Jobs Act (TCJA) of 2017

The TCJA intro­duced sev­er­al changes that impact real estate invest­ment, includ­ing DSTs and cost seg­re­ga­tion:

1. Bonus Depre­ci­a­tion now at 60%:
   • Expan­sion: The TCJA expand­ed bonus depre­ci­a­tion to 100% for qual­i­fy­ing prop­er­ty acquired and placed in ser­vice after Sep­tem­ber 27, 2017, and before Jan­u­ary 1, 2023. Cur­rent­ly in 2024 the bonus depre­ci­a­tion is at 60%. It will decrease by 20% in the next few years.
   • Applic­a­bil­i­ty: This means that cer­tain com­po­nents iden­ti­fied in a cost seg­re­ga­tion study can be ful­ly depre­ci­at­ed in the first year, pro­vid­ing sig­nif­i­cant tax sav­ings.
   • Recap­ture Depre­ci­a­tion: If the prop­er­ty is even­tu­al­ly sold with­out anoth­er 1031 exchange the depre­ci­a­tion will be recap­tured.
2. Qual­i­fied Improve­ment Prop­er­ty (QIP):
   • Cor­rec­tion: The TCJA ini­tial­ly omit­ted QIP from 15-year recov­ery eli­gi­bil­i­ty, but this was cor­rect­ed in the CARES Act of 2020. QIP is now eli­gi­ble for 15-year depre­ci­a­tion and 60% bonus depre­ci­a­tion.
   • Impact on DSTs: Improve­ments made to prop­er­ties with­in DSTs can ben­e­fit from these pro­vi­sions, enhanc­ing depre­ci­a­tion deduc­tions.
3. Sec­tion 179 Expens­ing:
   • Increased Lim­its: The TCJA increased the max­i­mum deduc­tion for Sec­tion 179 expens­ing and expand­ed the def­i­n­i­tion of qual­i­fy­ing prop­er­ty.
   • Rel­e­vance: While Sec­tion 179 is more com­mon­ly used for small­er invest­ments, it can still be rel­e­vant for cer­tain com­po­nents in DST-held prop­er­ties.

Com­bined Ben­e­fits of DSTs and Cost Seg­re­ga­tion:

• Tax Effi­cien­cy: Com­bin­ing the pas­sive invest­ment ben­e­fits of DSTs with the tax sav­ings from cost seg­re­ga­tion can sig­nif­i­cant­ly enhance the after-tax returns for real estate investors.
• Cap­i­tal Gains Defer­ral and Depre­ci­a­tion: DSTs pro­vide a vehi­cle for defer­ring cap­i­tal gains through 1031 exchanges, while cost seg­re­ga­tion pro­vides imme­di­ate tax sav­ings through accel­er­at­ed depre­ci­a­tion.
• Improved or Enhanced Cash Flow: The com­bi­na­tion of these strate­gies can lead to improved cash flow, enabling investors to rein­vest and grow their port­fo­lios more effec­tive­ly.

Con­clu­sion

The com­bi­na­tion of DSTs, cost seg­re­ga­tion, and the pro­vi­sions of the TCJA can sig­nif­i­cant­ly enhance the tax effi­cien­cy and finan­cial per­for­mance of real estate invest­ments. By lever­ag­ing accel­er­at­ed depre­ci­a­tion and bonus depre­ci­a­tion, investors can achieve sub­stan­tial tax sav­ings and improved cash flow, mak­ing DSTs an attrac­tive option for those seek­ing pas­sive income and tax defer­ral oppor­tu­ni­ties. As always check with your finan­cial advi­sor if uti­liz­ing the cost seg­re­ga­tion analy­sis and reports are ben­e­fi­cial in your indi­vid­ual tax sit­u­a­tion. The Poten­tial rewards may be sig­nif­i­cant. As a side note you may be able to refile back one year if you qual­i­fy.

DSTs are not for all investors. The acqui­si­tion of a DST is for accred­it­ed investors only. Con­tact your invest­ment advis­er for addi­tion­al details on how a DST may be a solu­tion to your 1031 Exchange and suit­ed for your invest­ment future. For more infor­ma­tion on how to prop­er­ly set up an IRC §1031Tax Deferred Exchange or if you are an accred­it­ed investor and would like addi­tion­al infor­ma­tion on a DST con­tact Al DiNi­co­la at 239–691-8098 or email adinicola@namcoa.com.

This is not an offer to pur­chase or solic­i­ta­tion to pur­chase any secu­ri­ty, as such be made only through an offer­ing mem­o­ran­dum or prospec­tus. Invest­ing in secu­ri­ties, real estate, or any invest­ment, whether pub­lic or pri­vate, involves risk, includ­ing but not lim­it­ed to the poten­tial of los­ing some or all of your invest­ment dol­lars when you invest in secu­ri­ties. You should review any planned finan­cial trans­ac­tions that may have tax or legal impli­ca­tions with your per­son­al tax or legal advi­sor. NAMCOA, LLC is a Reg­is­tered Invest­ment Advi­sor, reg­u­lat­ed by SEC (Secu­ri­ties and Exchange Com­mis­sion).

Our cor­po­rate office is locat­ed at 999 Van­der­bilt Beach Road, Suite 200, Naples Flori­da 34108. Secu­ri­ties Offered through MSC-BD, LLC, Mem­ber of FINRA/SIPC. 8215 SW Tualatin-Sher­wood Rd, Suite 200 Tualatin, OR 97062.  MSC-BD, LLC and NAMCOA are inde­pen­dent­ly owned and are not affil­i­at­ed.

Thank you.