Delaware Statutory Trusts (DSTs) often pique the interest of investors seeking access to substantial commercial real estate (CRE) assets akin to those held by institutional investors. A DST comes into existence through the efforts of a sponsor who identifies and acquires the targeted assets. Subsequently, the sponsor promotes the offering to potential investors and enters into an agreement with a master tenant to oversee property management.
The necessity for a master tenant arises because DST regulations prohibit the sponsor from renegotiating leases or loans related to the assets. While DSTs generally specialize in a specific CRE sector, such as multifamily housing, office, or retail, each DST may possess multiple properties. According to DST regulations, the trust must consistently distribute at least 90% of its income to the beneficiaries. Since DSTs function as pass-through entities, the trust itself does not incur taxes on its income. Instead, each shareholder (beneficiary) is responsible for paying income tax according to their individual tax rate.
When will I receive the return on my principal investment?
DSTs operate within a predetermined lifespan, typically established from the outset, often ranging from five to ten years. Alternatively, some DSTs have termination dates contingent upon specific achievement milestones. In either scenario, the sponsor will notify the trust’s beneficiaries when the disposition phase commences. Only after the disposal of the held properties does the DST investor regain their principal investment.
Investors must grasp that DSTs are illiquid investments. Naturally, like all other investment vehicles, DSTs carry the potential risk of depreciating in value. Potential investors should diligently examine the Private Placement Memorandum (PPM) and assess the sponsor’s qualifications and track record.
What occurs upon the termination of the DST?
As DST investors prepare to receive their payout from the trust, they have several options to consider:
- Paying Taxes on Capital Gain
- When a DST is terminated, investors may opt to receive their payout directly, which typically involves realizing a capital gain. This gain results from the increase in the value of the DST’s real estate assets during the investment period.
- Capital gains tax is levied on this profit, and the rate depends on various factors, including the holding period of the investment and the investor’s individual tax bracket. It’s important to note that capital gains can be subject to federal, state, and possibly local taxes.
- Investors should be aware of the tax implications and consult with tax professionals to plan accordingly. They may also explore strategies to minimize their tax liability, such as using any available tax deductions or credits.
- Using Proceeds for a 1031 Exchange into “Like-Kind” Property:
- Another option for DST investors upon termination is to utilize the proceeds from the DST to participate in a 1031 exchange, which allows them to defer paying capital gains taxes.
- In a 1031 exchange, investors reinvest the proceeds into a new “like-kind” property, which is typically a real estate asset of a similar nature or purpose. This exchange must adhere to specific IRS guidelines, including identifying the replacement property within 45 days and completing the transaction within 180 days.
- The benefit of this approach is that it allows investors to defer capital gains taxes until a later date when they eventually sell the replacement property. This strategy provides potential tax savings and preserves more of the investor’s capital for future investments.
- Performing a 1031 Exchange into Another DST:
- A unique advantage of DSTs is the ability to use the proceeds from one DST to invest in another DST through a 1031 exchange. This strategy is particularly appealing to investors who wish to continue their involvement in the DST investment model.
- By moving the funds into another DST, investors maintain the potential for tax deferral while gaining exposure to a new set of real estate assets. This can contribute to diversification within their investment portfolio.
- The flexibility of choosing another DST allows investors to tailor their investment to meet specific criteria, such as different sectors of commercial real estate or geographic locations.
- It’s essential to conduct thorough due diligence when selecting a new DST, assessing its potential for income generation, capital appreciation, and risk factors.
The three considerations for DST investors, when a DST is terminated, involve making decisions regarding taxation, such as paying capital gains taxes or utilizing a 1031 exchange for tax deferral. The latter option includes either investing in a new “like-kind” property or transferring the funds into another DST. Each choice comes with its own set of advantages and potential drawbacks, and investors should carefully evaluate their financial goals and consult with professionals to make informed decisions that align with their investment strategies.
Employing a 1031 exchange for both entry into and exit from a DST represents a distinct advantage of this investment vehicle. Real estate investors can enter a DST using a 1031 exchange and may also sell a direct investment, using a 1031 exchange to invest in another DST. Some key advantages of this approach include:
- Expedited transaction closure after selling the relinquished asset. 1031 exchanges adhere to strict deadlines, including a 45-day period for identifying potential replacement property and a total of 180 days to complete the transaction. Often, investors can identify and execute a 1031 exchange into a DST within a shorter timeframe.
- The flexibility to customize the investment amount. Occasionally, investors may encounter challenges in matching the value and debt level of their relinquished assets. Investing in one or more DSTs resolves this issue by allowing for specific dollar amount investments, either meeting or exceeding the DST minimum requirement.
- The opportunity to diversify their investment portfolio by selecting DSTs with different focuses on various sectors and geographic regions.
- The option to transition from active management to passive investment while retaining access to income.
DST investors may enjoy the benefits of fractional ownership of properties that might be financially out of reach individually. Additionally, they benefit from professional property management and the potential for reliable, tax-advantaged income and capital appreciation.
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