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DST 1031 – what does it mean for investors?

What do investors mean when they talk about a DST 1031 property? Let’s take a look.

Delaware Statutory Trust

DST is an acronym for Delaware Statutory Trust. This is a way of owning real estate without being active. In other words, investors are not involved in the day-to-day headaches that come with property management. For example, they don’t have to deal with collecting rents, maintaining the space, or dealing with a tenant, etc.

Unlike an LLC (Limited Liability Company), a DST 1031 investment qualifies as “like-kind” replacement property for a 1031 exchange. Generally speaking, a like-kind property means that the replacement property is of “the same nature or character, even if [it differs] in grade or quality.” For example, an apartment building is generally considered like-kind to another apartment building. DSTs came from statutory law in Delaware and qualify under Section 1031 as a separate legal entity for a tax-deferred exchange.

What do we mean by DST 1031?

In 2004, the Internal Revenue Service (IRS) made a ruling (2004-86) that specified how a DST can be structured in order to qualify replacement properties for 1031 exchanges.

If an investor sells their property to invest in a DST, they can defer the capital gains taxes with a 1031 exchange. However, the investor must identify a replacement property within 45 days, or they will have to pay the capital gains tax and the Depreciation Recapture Tax as well as state taxes and even an NIIT (surtax on Medicare).

Accredited investors can use the 1031 exchange to defer their taxes. An accredited investor is a business entity or individual that can trade securities that aren’t registered with a financial authority. This privilege is an entitlement due to satisfying criteria about their net worth, income, governance status, personal experience or asset size.

The SEC (Security and Exchange Commission) states that an accredited investor needs to have a net worth in excess of $1 million (not including equity in their home) or a net income of at least $200k for two years (rising to $300k joint with a spouse). They also need to have an expectation of earning an equal amount in the coming year.

Owing to 1031, investors can put off paying tax by reinvesting any proceeds they have in a similar property.

Types of DST 1031

With a DST 1031 exchange, an investor can get involved in owning a high-value commercial property that otherwise they couldn’t afford. For example, it could be a 150,000 sq-ft office building, a 500-unit apartment block, or a retail center. Other types of properties that are available as DST 1031 exchanges include medical facilities and self-storage properties. These are typically long-term lease properties.

Financing a DST 1031 property

Typically, DST 1031 properties use non-recourse financing. Non-recourse financing means the lender can seize the collateral in case of default. However, the lender is not able to seize any other assets, even when the collateral market value is less than any money owed. So, if there were to be a depression or market-wide recession, the investor could lose their investment amount. However, the lender wouldn’t have any right to the investor’s other assets. Therefore, some DST 1031 properties are offered without financing as all-cash in order to mitigate the risks that financing has.

Is it possible to 1031 out of a Delaware Statutory Trust?

Yes. There are two scenarios when you can do this.

First scenario: When the investors sell the property, i.e. it goes “full cycle”. Whenever the sponsor of the DST has sold on the asset according to the business plan, individual investors can enjoy the options they had when they first got into the DST. For example, they can exchange into another DST, exchange into another property, or pay the taxes.

Second scenario: When individual investors want to sell their DST before the property is full cycle. This is more difficult because DST investments are not considered to be liquid investments. There isn’t a public market where investors are able to sell on their DST ownership interests. This is why investors should only buy a DST on a 1031 exchange if they can keep it for between five and ten years. There could be secondary markets for selling early, but rules will apply like selling traditional investment properties.