For real estate owners considering a Section 1031 exchange, one of the replacement-property alternatives they may encounter is a Delaware Statutory Trust, commonly referred to as a DST.
A DST is a legal trust structure that can hold title to one or more real estate properties. Investors acquire beneficial interests in the trust, allowing multiple investors to participate in the ownership of the real estate without assuming the day-to-day responsibilities of directly managing the property.
Properly structured DST interests may also qualify as replacement real property in a Section 1031 tax-deferred exchange.
For some investors, DSTs may provide a way to transition from actively managing real estate to a more passive form of real estate ownership. However, DSTs also involve important risks, limitations, fees, liquidity considerations, and eligibility requirements that should be understood before investing.
What Is a DST?
A Delaware Statutory Trust is formed under Delaware law and may be used to own real estate and other assets.
In a typical real estate DST offering, the trust acquires one or more income-producing properties. Investors purchase beneficial ownership interests in the trust rather than purchasing and managing an individual property themselves.
Although multiple investors participate in the trust, the DST itself holds title to the underlying real estate.
A professional sponsor or asset manager generally oversees the investment, while property management may be handled by an affiliated or third-party property manager.
Investors generally do not make the day-to-day operational decisions associated with direct real estate ownership.
The Legal and Tax Foundation of DSTs
An important development in the use of DSTs for Section 1031 exchanges occurred when the Internal Revenue Service issued Revenue Ruling 2004–86.
Under the facts described in that ruling, the IRS concluded that the Delaware statutory trust was treated as an investment trust for federal tax purposes and that each beneficial owner was considered to own a proportionate interest in the underlying real estate for federal income-tax purposes.
The ruling further concluded that a taxpayer could exchange qualifying real property for an interest in the DST described in the ruling without recognition of gain or loss under Section 1031, provided the other requirements of Section 1031 were satisfied.
This ruling became an important foundation for the modern use of properly structured DST interests as potential replacement property in Section 1031 exchanges.
It is important to understand that not every trust interest automatically qualifies for Section 1031 treatment. The structure must satisfy applicable tax requirements, and the taxpayer must independently satisfy the requirements of the exchange.
How Does a DST Work?
The basic structure is relatively straightforward.
A DST sponsor identifies and acquires real estate for the trust. The real estate may be purchased with cash, financing, or a combination of both, depending on the offering.
Interests in the trust are then offered to eligible investors.
Instead of individually owning and managing an entire apartment building, industrial facility, medical office building, retail center, or other property, the investor acquires a fractional beneficial interest in the DST that owns the property.
The investor’s ownership percentage generally determines the investor’s proportionate participation in the economics of the trust, subject to the terms of the offering documents.
If the property generates distributable cash flow, investors may receive periodic distributions. Distributions are not guaranteed and can increase, decrease, or be suspended.
When the DST eventually sells its real estate, investors generally receive their proportionate share of the net proceeds, subject to the terms of the offering and applicable expenses and liabilities.
How Can a DST Be Used in a 1031 Exchange?
Section 1031 generally permits an owner of qualifying real property held for investment or productive use in a trade or business to exchange that property for other qualifying like-kind real property and defer recognition of eligible gain.
Since 2018, Section 1031 generally applies only to qualifying real property, not personal or intangible property.
A properly structured DST may potentially serve as replacement real estate in that exchange.
For example, an investor may sell a rental property and determine that he or she no longer wants the responsibilities associated with owning another rental property directly.
Instead of locating, negotiating, financing, closing, and managing another individual property, the investor may consider acquiring beneficial interests in one or more qualifying DST properties as part of the replacement-property strategy.
A DST can also potentially be combined with directly owned replacement real estate. The appropriate strategy will depend upon the taxpayer’s objectives, exchange requirements, liquidity needs, risk tolerance, tax situation, and available replacement properties.
A DST does not eliminate the requirements of Section 1031. Investors must still properly structure the exchange and comply with applicable identification, timing, ownership, qualified-intermediary, and other tax requirements.
What Types of Real Estate Can DSTs Own?
DST offerings may invest across a wide range of commercial real estate sectors.
Common property types include multifamily apartment communities, student housing, senior housing, manufactured housing communities, single-family rental and build-for-rent communities, self-storage facilities, industrial and logistics properties, medical office buildings, net-leased properties, necessity retail, grocery-anchored retail, and other specialized real estate sectors.
The underlying property is extremely important.
Investors should evaluate a DST not simply because it is a “DST,” but based on the quality and economics of the actual real estate, the sponsor, tenants, leases, market, financing, business plan, fees, projected holding period, potential exit strategy, and risks.
A DST is an ownership structure—not an asset class.
Why Do Some Real Estate Investors Consider DSTs?
One of the primary reasons investors evaluate DSTs is the desire to move from active real estate management to passive ownership.
A longtime landlord, for example, may own valuable appreciated real estate but no longer want responsibility for tenants, repairs, leasing, capital improvements, insurance, employees, vendors, property management, or other operational issues.
Selling the property outright could create a substantial taxable gain.
A Section 1031 exchange may provide an opportunity to defer eligible gain, and a DST may be one of several potential replacement-property alternatives.
Other investors may evaluate DSTs because they want access to different property sectors or geographic markets, want to divide exchange proceeds among several properties rather than purchase a single replacement property, or are working within the relatively short time requirements of a Section 1031 exchange.
These considerations do not automatically make a DST appropriate. They simply explain why DSTs are frequently evaluated during the replacement-property process.
Potential Benefits of a DST
Depending upon the investor and the specific offering, potential benefits may include Section 1031 exchange eligibility, passive real estate ownership, professional asset and property management, access to larger commercial properties, geographic or property-type diversification, and the ability to allocate exchange proceeds among multiple replacement properties.
DSTs may also be useful when an exchanger needs a specific amount of replacement real estate to complete an exchange because DST interests can often be acquired in increments substantially smaller than the purchase price of the entire underlying property.
These potential benefits should always be evaluated together with the investment’s risks and limitations.
Important Risks and Limitations
DSTs are real estate investments and securities and involve risk, including the potential loss of principal.
One of the most important considerations is liquidity. DST interests are generally designed as longer-term investments and do not trade like publicly listed stocks or publicly traded REITs. An investor should not assume that a DST interest can be sold whenever cash is needed.
Investors also surrender substantial operational control. Decisions concerning leasing, financing, property management, capital expenditures, and disposition of the property are generally made by the sponsor or other authorized parties rather than individual investors.
Other risks can include changes in property values, tenant defaults, vacancies, economic downturns, interest-rate changes, leverage, refinancing risk, unexpected property expenses, sponsor performance, geographic concentration, sector concentration, disposition timing, tax-law changes, and conflicts of interest.
Projected distributions, appreciation, holding periods, and exit values are estimates—not guarantees.
Before investing, an investor should carefully review the applicable Private Placement Memorandum or other offering documents, including the risk factors, fees, conflicts, financing, property information, sponsor background, and exit assumptions.