The 411 on Alternative 1031 DST Exchanges

Aug 28, 2020

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How seasoned investors build smarter portfolios with passive income-producing real estate

Many of our seasoned real estate clients are familiar with an  alternative 1031 exchange structure know as a  DST (short for Delaware Statutory Trust). This 1031 investment strategy  provides numerous tax benefits, and the opportunity for wealth creation in a simple turnkey  process. While most investors understand how they benefit from a 1031 exchange, they’re much less clear about alternative investment strategies that can optimize diversification and potentially reduce risk. In particular, investors are uncertain about what property sectors will offer the greatest potential in a post-COVID environment. 

Purchasing a property outright is common strategy for new investors. However, many looking for retirement-friendly options and lifestyle income want something hands-off – with durable and predictable monthly income.  Here are a few reasons why real estate investors might want to consider an alternative 1031 DST exchange.   

Understanding the DST Structure

In 1998, Delaware passed the Delaware Business Trust Act (renamed in 2002 as the Delaware Statutory Trust Act), which modernized the state laws for trust creation and management to better suit investors. This act helped investors bypass the tricky and disadvantageous legal proceedings for trust management in several ways:

  • Real Estate Trust: Because indemnification, management of the trust, rights and obligations, and enforcement of such agreements are dictated by the trustees and not the individual investors, DST owners can benefit from treatment as a passive real estate trust versus an actively owned and managed business trust.   
  • Confidentiality: Delaware doesn’t require the filing of the trust agreement with the state, which means that these agreements can also be kept confidential to anyone outside the DST.
  • Real Assets: In 2004, the IRS granted approval for DSTs to purchase  real estate. This ruling enabled beneficial interest to be acknowledged as a replacement property in a 1031 exchange for tax purposes. DSTs can have up to 2,000 investors as beneficial owners, and they can include qualified  IRC 1031 tax deferred exchanges as well as non-1031 cash investments.      

As an alternative 1031 investment vehicle, DSTs can offer benefits not found in other traditional 1031 exchange properties. First, DSTs offer asset diversification and personalized portfolio construction. In a DST structure, a real estate investment management firm will serve as the sponsor for the trust, acquiring specified properties to attract investors. These properties are typically higher quality and generally diversified by property sector, investment manager (sponsor), and geography. Also, given the institutional-quality and size of DST property holdings, most investors don’t have adequate capital to purchase these properties outright. Owning a fractional share in a diversified portfolio of DSTs can potentially reduce risk and enhance overall investment returns.   

By offering DST ownership interests to multiple owners, investors can tailor their DST selections and investment amounts to match individual risk profiles and investment objectives. They can use their proceeds from a qualified 1031 exchange or invest cash as an alternative to stocks and bonds.   

Advantages of DSTs

DSTs offer the investor a simple way to transition from active to passive ownership with income-producing real estate. The passive income from the beneficial interest can be used for retirement, lifestyle expenses, and other interests — without the responsibility and burden of property management.  While every investment presents an element of risk, DSTs can offer advantages over directly owned and managed properties. Some of the benefits, include:   

  • Immediate Closing: DSTs are pre-structured and existing investment programs that offer immediate identification and property closing. Many investors are finding it difficult to source, underwrite, and finance their 1031 exchange property within the IRS proscribed 45-day identification timeframe. Certainty of close and the potential to start generating immediate monthly cash flow is one the main reason investors are attracted to DSTs. 
  • Diversification: Diversifying investments is the golden rule of any real estate investment strategy.  By choosing a DST, investors can diversify away from one single investment to multiple DST investments. 
  • Lower Minimal Investment: Because a DST is open to up to multiple investors, the minimum investment required can be as low as $100,000 and tailored to suit an individual’s needs and goals. 
  • Upgraded Property Holdings: DSTs can  help investors offload unproductive or lesser quality assets, such as raw land or rental properties with a high value but poor rental rates. Investors can effectively use the proceeds  from an asset sale to invest in a diversified portfolio of higher quality, income producing assets, while maintaining 1031 tax deferral.  This process can continue after the death of the DST investor so that the beneficiaries can inherit a tax-free transfer of these passive real estate investments with a stepped-up basis.   
  • Passive Income: An investment in a DST meanselimination of the“terrible T’s” of active real estate management: toilets, trash, and tenants. Investors can focus on asset allocation and overall portfolio management as opposed to day-to-day property management.    

Alternative 1031 DST exchanges can help investors make savvy choices that build smarter portfolios and potentially achieve better outcomes. In addition to helping investors break free from the constraints of active property management, DSTs can provide current tax efficient income — and forge a path to compounded wealth creation and financial stability.

Petra Capital Properties, managed by Brad Watt, specializes in purpose-built fractional 1031 DST programs. These pre-structured DST offerings begin at $100,000 and are personally constructed  by the Petra team. Learn more about investment options by contacting Petra Capital Properties and following us on LinkedIn and  Facebook.