FAQs of DSTs
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A 1031 Exchange can seem rather complicated at first but at Petra Capital Properties we will help simplify your transaction.
What is a Delaware Statutory Trust?
A Delaware Statutory Trust, also known as a DST, is a legal entity created as a real estate trust under Delaware law. The DST is the owner of the property or properties, and holds title and deed to the investment property. A DST is an alternative 1031 investment structure that meets the requirements of a qualified replacement property interest under 1031 exchange rules.
What are some of the key features of DST property ownership?
When investors participate in a DST, they can enjoy passive income without the active day-to-day property management obligations. This is because the Sponsor takes on the property management duties until the property is sold. While the DST owns the properties, each investor owns a proportional interest in the DST.
What are the primary benefits of a DST?
A DST is a pre-structured or programmatic solution to a 1031 replacement property. Because the DST is already formed and operating at the time of investment, the DST investor can have peace of mind knowing that they can meet their IRC 1031 required 45-day identification rule and 180-day closing time frame. Additional benefits include:
- Immediate access to high-quality properties
- Certainty of close
- Professional third-party property management
- Matching mortgage debt allocation with no personal recourse
- Passive (monthly) income
- Potential for upside capital appreciation
What do existing investors say about investing in DSTs?
Compared to sole ownership, purchasing a replacement property interest in a DST structure can be a simpler and quicker process. For many 1031 exchange investors, the 45-day identification window can be stressful and risky. The competition for quality properties is fierce and oftentimes results in untimely bidding wars with failed execution. Also, in a COVID-19 environment, completing property due diligence and third-party inspections within the proscribed 45-day identification period can be challenging.
By investing with others rather than as a sole owner, investors can realize the benefits of higher quality property ownership with greater diversification. Also, because the DST minimum investment starts at $100,000, investors are able to invest in multiple DSTs, further reducing exposure to single-property ownership risk.
One the main features that DST investors enjoy is the elimination of personal loan guarantees for mortgage debt. Most DSTs are structured with long-term, fixed rate financing, and loan payments are serviced through rental income. Investors in a DST will typically pay off the balance of their relinquished property debt at closing and assume a like-kind amount of debt in the DST. Because the DST is the borrower under the loan agreement, individual investors are not responsible for the loan or debt payments. In this respect, DST investors are able to enjoy all of the benefits of debt financing without the personal recourse that banks typically require.
DST investors can defer capital gains and depreciation recapture tax, while generating (tax efficient) monthly income without the liability that comes with direct-property ownership. DST Investors also enjoy the benefits of professional third-party management versus active day-to-day property management. Other benefits of investing in a DST include portfolio diversification, projected monthly cash flow, and potential capital appreciation. When a property is sold, the DST owners can choose to complete another 1031 exchange.
Does a DST qualify as good 1031 replacement property?
Yes. An individual investor can use the DST as a qualified replacement property interest. IRC 1031, as further amended by revenue ruling 2004-86, states that a properly structured DST will qualify as a direct property investment. DSTs are marketed and sold through a private placement memorandum (PPM), which includes a legal opinion.
How are DST interests marketed and sold?
DSTs are considered Private Placements under the Securities Act of 1933. Although these private placements are sold as securities, they do not have to be registered with the Securities and Exchange Commission (SEC), provided they qualify for an exemption from registration as set forth in the Securities Act of 1933. An ownership interest in a DST is generally sold through a FINRA registered Broker Dealer and their registered representatives. Most DSTs include a commission to be paid to the Registered Representative, which is paid by the DST Sponsor and disclosed in the PPM.
What are the minimum and maximum investment amounts?
Most DSTs require a minimum $100,000 purchase for a 1031 replacement property interest. For non-1031 exchange investors, minimum cash investments start at approximately $25,000.
What qualifications are there for investing in a DST?
The SEC states that the definition of accredited investor is “intended to encompass those persons whose financial sophistication and ability to sustain the risk of loss of investment or ability to fend for themselves render the protections of the Securities Act’s registration process unnecessary.” The definition of accredited investor under Rule 501 includes several types of individuals and entities that qualify as “accredited.” Generally, an accredited investor is defined by income or net worth.
To qualify as an accredited investor based on your annual income, you must have had an annual income of $200,000 or greater (or $300,000 or greater combined income with your spouse) for the prior two years, and have a reasonable expectation of the same or greater income in the current year.
To qualify as an accredited investor based on your net worth, you must have a net worth of $1 million or more, calculated as total assets less total liabilities. You must exclude the value of your primary residence as an asset in the calculation.
Ownership & Income
What does my ownership interest look like in a DST?
A Sponsor (or experienced real estate company) puts together the DST offering and takes initial ownership of the property. Under the terms of a Purchase and Sale Agreement, the Sponsor transfers their ownership interest in the DST to individual purchasers of the DST beneficial ownership interests. Upon a purchase of a DST interest, the investor will receive a beneficial interest in the Trust, which is considered a qualified replacement property interest.
All owners receive a proportional interest in the income and expenses of the DST, including depreciation and interest expense deductions.
Who takes title to the DST property?
The Trust takes title to the property and each investor receives a pass-through ownership interest in the Trust. A purchase in a DST is considered a replacement property interest and qualifies as good replacement property under the IRC 1031 exchange rules. When there’s a group of investors pooling capital, each investor owns a fractional share of the property, reducing the risk of sole ownership and investment concentration.
How does a DST distribute its income?
DSTs are disregarded entities and exempt from federal and state tax reporting. In this respect, they are considered a “conduit” structure, with each individual investor responsible for their pro rata share of income, losses, and capital appreciation. This pass-through feature enables investors to hold their DST interest individually or as an entity. Each DST beneficial owner is responsible for their own tax reporting.
What are the risks associated with investing in a DST?
Like any investment, DSTs carry investment risk. DSTs are considered illiquid alternative investments and are subject to a variety of macro-economic and property specific risks. Generally speaking, DST risk includes:
- Reduction or loss of distributable cash flow
- Potential loss of capital
- Inability to access immediate liquidity
- Failure of the third-party sponsor/manager to sufficiently manage the property
- Failure of the Sponsor to collect rent from the tenants
Risk & Fees
Are there limitations to investing in a DST?
In this alternative 1031 investment structure, investors don’t have control over management, operations, or the sale of any property in the DST. In this respect, DSTs are a passive ownership vehicle. Investors must rely on the efforts of third parties to manage their investment. The success of the DST will depend on both external market conditions as well as the quality of sponsorship and management. DSTs are considered illiquid investments. As such, investors will not have immediate access to their investment capital. Investors who have short-term liquidity needs may not be suitable for a DST investment. As a possible alternative, these investors might want to consider a partial tax deferred exchange where they can receive cash at closing (with tax liability) and reinvest the reminder into a DST.
Are there fees associated with a purchase of a DST replacement property interest?
Yes. As with any direct investment in real estate, DSTs do include fees and expenses. These fees and expenses are generally referred to as “front-end-load” and are always disclosed in the PPM. The Sponsor of the DST determines the amount of fees and expenses charged to each DST program, generally following a best practices guideline.
When expressed as a percentage of the overall DST purchase price (i.e. equity and any non-recourse debt), most DST property interests are priced similarly to the purchase of a directly owned and managed property. Fees and expenses typically include real estate closing costs, DST offering costs, financing costs, and cash reserves.