Section 1031 allows an investor to sell real estate for a gain and roll the proceeds into another “like-kind” asset, and 1031 exchange Delaware Statutory Trust brokers help investors use Delaware Statutory Trusts as that replacement property so capital gains tax can be deferred rather than paid at the time of sale. This approach is aimed at real estate investors who want tax deferral through a 1031 exchange but may prefer a DST over buying and managing another property directly.
Tax deferral means that the taxes are not due now. Rather, the taxes are on hold until a later date, perhaps years in the future. The deferred taxes on the sale of the property will eventually become due one day when the replacement like-kind property is sold without another 1031 exchange.
For investors weighing that option, the key questions are how Section 1031 rules work, what a Delaware Statutory Trust is, how a DST qualifies for a 1031 exchange, and the advantages and drawbacks of using one. The payoff is practical: deferring capital gains can leave more money invested, while a DST can offer simpler property acquisition, broader diversification, and a shift from active ownership to a more passive real estate investment.
1031 Exchange Rules: Tax Deferral on Capital Gains
As with everything at the IRS, 1031 exchanges have many rules. If these rules are not carefully followed, the transaction will not qualify for tax deferral.
Section 1031 of the Internal Revenue Code allows an investor to reinvest the proceeds from the sale of business or investment real estate into a “like-kind investment.” This rule applies to residential rental property (such as a rental home or apartment building) or commercial property (such as a warehouse or office building). A primary residence or a second home does not qualify for 1031 treatment.
If the transactions meets all the rules of Section 1031, the investor defers paying capital gains tax on the net profits from the sale. As a result, the investor may use all of the equity from the sale to invest in a new piece of property (the like-kind property), without worrying about current taxes.
The most common type of 1031 exchange requires a third party, known as a qualified intermediary (or QI). The function of the qualified intermediary is to facilitate the sale of the property and to guarantee that the proceeds are used to buy new property which qualifies under the 1031 rules.
The qualified intermediary (QI) holds the proceeds from the sale of the relinquished property in escrow. After the sale, the investor has 45 days to identify replacement property to purchase. The investor then has 180 days from the sale to purchase the new property, and this is the critical deadline for completing the exchange.
If these rules are met, then the transaction will qualify for deferral of capital gains taxes as a Section 1031 like-kind exchange.
What is a Delaware Statutory Trust?
A Delaware Statutory Trust, or DST, is a fractional real estate investment, similar in function to a limited partnership where a number of investors pool their capital. It is a legal entity that allows investors access to a fractional interest in real estate that is owned by the trust. Investors acquire a beneficial interest in the trust rather than direct title to the property. The Delaware Statutory Trust provides investors with limited liability, pass-through income and cash distributions.
The sponsor of a Delaware Statutory Trust uses its own capital to acquire property through this investment vehicle, which holds the underlying real estate and may be owned by multiple investors through fractional ownership. In exchange for a management fee, the sponsor does all due diligence on the property, secures long-term debt, oversees the investment and manages the operation of the property. Many offerings are available only to accredited investors, and DSTs typically require a minimum investment of $100,000.
1031 Exchange and the Delaware Statutory Trust
In 2004, the IRS Revenue Ruling, Revenue Ruling 2004-86, established that a Delaware Statutory Trust (DST) can qualify as replacement property in a 1031 exchange. This means that investors who are selling property can defer paying capital gains tax by investing the proceeds of the sale into a DST structure that qualifies only if it follows the ruling’s requirements. The trust qualifies as a “like-kind” investment. DSTs must adhere to Revenue Ruling 2004-86 rules to preserve their tax-qualified status.
In other words, a Delaware Statutory Trust is an alternative to the direct purchase of like-kind property under the 1031 exchange rules.
Pros and Cons of Using Delaware Statutory Trusts for a 1031 Exchange
Not surprisingly, a Delaware Statutory Trust has both pros and cons for Section 1031 exchange transactions. Here is a summary.
The Pros of a Delaware Statutory Trust for Section 1031
Transferring the proceeds of a sale into a Delaware Statutory Trust is much simpler than investing directly in another like-kind property. Because the DST sponsor has already conducted due diligence and purchased the property, an investor looking to make a 1031 exchange can work with brokers to evaluate replacement property options and identify suitable Delaware Statutory Trust properties within the strict timelines of Section 1031. Once an investor identifies a DST that they like, a DST offering can often close within 3 to 5 business days after a sale. Brokers also provide due diligence on DST companies, the sponsor, and the offering before an investor commits capital.
The Delaware Statutory Trust offers investment diversification. Investors looking to complete a 1031 exchange may invest in one or more DSTs, or a DST with multiple properties. The DSTs may invest in different property types, with different sponsors, and in different geographies, giving investors access to a broader mix of real estate assets.
DSTs are able to invest in institutional grade assets, the type usually reserved for university endowments, pension funds, hedge funds and the very wealthy, and many include pre-arranged nonrecourse financing.
Lastly, those who invest in a Delaware Statutory Trust hand off the management obligations of the property to the DST sponsor, reinforcing the passive nature of the ownership structure and freeing themselves from the day to day responsibility of direct ownership. In essence, a 1031 exchange combined with a DST allows an investor to move from active to passive ownership of real estate, while maintaining the tax benefits of owning real estate directly.
Thus, the investor in a Delaware Statutory Trust will no longer have to worry about property management, hiring brokers and attorneys, arranging financing, routine maintenance and repairs, marketing and leasing, while sponsor-led asset management supports the passive investment approach. All this becomes the responsibility of the DST sponsor.
If you don’t want to be landlord, then a Delaware Statutory Trust is a great way to go.
The Cons of a Delaware Statutory Trust for Section 1031
Once a Delaware Statutory Trust offering is closed, no additional capital contributions are permitted to the DST by either existing or new investors. And holding periods for DST investments usually range from 5-10 years, so the investment is not liquid across the full investment cycle.
A Delaware Statutory Trust cannot borrow more funds, renegotiate the terms of existing loans or reinvest sale proceeds from the sale of its real estate.
It has limited authority to make capital expenditures beyond normal repair and maintenance.
Any cash reserves being held between distribution dates may only be reinvested in the trust’s short-term debt obligations. All cash, other than necessary reserves, must be distributed to investors on a regular basis. So flexibility is somewhat limited.
DST fees paid to the sponsor can be substantial.
Because the Delaware Statutory Trust is professionally managed, the investors will not have day to day control over the property. This can be seen as a pro or con, depending on the wishes and personality of the investor. DST investors also face risks tied to property vacancies and changing market conditions, which can affect cash flow.
Delaware Statutory Trusts: In Summary
A 1031 exchange is a boon to the investor looking to defer taxes on capital gains through broader tax deferral strategies, reduce current tax liability, and grow (or at least maintain) a healthy real estate portfolio. With the help of a qualified intermediary and a CPA, a 1031 exchange should move forward easily and with minimal risk. Provided all the IRS rules are followed.
The Delaware Statutory Trust, or DST, is an option for the investor looking to do a 1031 exchange, with delaware statutory trust investments offering a DST investment that can fit an investment strategy focused on passive ownership and tax deferral. The Delaware Statutory Trust has pros and cons, which should be carefully considered in light of the needs and concerns of the investor, and a broker can help align the structure with the investor’s goals.
For more information on DSTs, I suggest contacting Lance Stafford at Perch Wealth
Massey and Company CPA is a boutique tax and accounting firm serving individuals and small businesses in Atlanta, Chicago and throughout the country. Our services include tax return preparation, tax planning for businesses and individuals, IRS tax problem resolution, IRS audits, and small business accounting and bookkeeping.
