Opportunity Zone Pitch Day - March 23rd
Introduction To DSTs For Real Estate Investors
Delaware statutory trusts (DSTs) offer unique diversification opportunities and tax advantages for real estate investors. Learn more about the pros and cons of this special type of 1031 exchange.
Click the play button above to listen to our conversation.
- The basics of Internal Revenue Code Section 1031, and how a real estate investor can execute a 1031 exchange to defer capital gains tax liability indefinitely.
- Why 1031 exchanges are crucial to the real estate marketplace.
- Timing rules of executing a 1031 exchange, including the 45-day rule and the 180-day rule.
- Why a real estate investor who no longer wants to deal with the “three T’s” may be ideally suited to consider a Delaware statutory trust (DST).
- The types of investors that a DST may be suitable for.
- The “Seven Deadly Sins” — IRS regulations that limit the power of DST trustees, and the implications of these regulations.
- The many advantages of investing in DSTs vs. a conventional 1031 exchange, including access to fractionalized institutional grade properties, passive hassle-free investing, and diversification.
- Some disadvantages of investing in DSTs, including illiquidity, limited upside, and lack of decision making ability.
- How you can determine if a DST investment may be right for you.
Featured On This Episode
- Internal Revenue Code § 1031
- Investopedia: 1031 Exchange
- Wikipedia: Delaware statutory trust
- Free Guide: Delaware Statutory Trusts Explained
- Free Guide: Top DST Picks For 1031 Investors
About The Alternative Investment Podcast
The Alternative Investment Podcast covers new trends in the alternate investment landscape. Hosts Jimmy Atkinson and Andy Hagans discuss diversification opportunities in the alts universe, including direct investments, DSTs, opportunity zones, private equity and more.
Jimmy: Welcome to the Alternative Investment Podcast. I’m your host, Jimmy Atkinson. We did it. We made it through episode 1. We’re on to episode 2. So we’re really hitting the ground running now. So today’s episode is gonna focus on Delaware Statutory Trusts, also known as DSTs. And joining me as always is my co-host, Andy Hagans. Andy, how are you doing?
Andy: I’m doing fantastic. How are you, Jimmy?
Jimmy: I’m great. I’m ready to dive in to episode 2 here with you. I’m really looking forward to this episode, all about DSTs, which form basically an alternative to a traditional 1031 exchange. So before we dive into DSTs, I feel like we need to do a 101 crash course on what a 1031 exchange is. Andy, Section 1031 and a 1031 exchange, what can you tell us about it?
Andy: Sure. And I know for a lot of our listeners, they’re already familiar with 1031 exchanges, although some of the regulations surrounding them changed in 2017, but I’m gonna start at the very beginning just in case we have any listeners who aren’t familiar with 1031 exchanges. So a 1031 exchange is a way to exchange one like-kind property for another while deferring the capital gains taxes owed from the sale of the first property, right?
So if an investor owns an investment property or a piece of real estate, and the investor sells this investment property for a capital gain, then invest the proceeds in a new property, normally taxes would be owed on the capital gain from the sale of the first property. But if the investor utilizes a 1031 exchange and there’s a lot of qualifications, there’s a lot of rules and regulations, and especially, time tables that you need to make sure that they’re crossing their t’s and dotting their i’s. But if they do a 1031 exchange correctly, they can defer that entire capital gain, and importantly, they can do it over and over, over time, right?
So the investor can own property A, sell that for a capital gain, swap it into property B with the 1031 exchange, own property B for a while. Sell property B for another capital gain, and again utilize that 1031 exchange to exchange into property C, all the while deferring these capital gains indefinitely, right? So we say swap till you drop. And it’s a great way for investors, real estate investors to improve a property or hold on to it, but then cash in those chips, lock in that capital gain without triggering that capital gains tax event, right?
If you could kind of imagine a world without the 1031 exchange, the real estate market would be a lot slower. It’d be a lot less efficient because investors just wouldn’t be motivated to sell and buy, and do as many deals. So we should mention that only certain types of property qualify for 1031 exchange treatment after 2017. So it used to be that certain types of personal property could qualify, but now it must be an investment in real estate property. And the replacement property in a 1031 exchange should be of greater or at least equal value than the one being sold, otherwise the difference in value will end up being taxable.
So one other aspect that I wanna go over briefly here are the two key timing rules that govern the 1031 exchange. Okay? And the first is the 45-day rule. So a taxpayer has 45 days from the date that the original sold property closes to identify up to 3 replacement properties that he or she intends to exchange into, right? So they may have three prospects. They’re not sure which of the three they’ll end up closing on, but they can identify up to three. But they need to do so within that 45 days. And then secondly, the 180-day rule.
So the taxpayer must then complete the total transaction within 6 months. And note that the 45 days is within the 180 days. It’s not in addition to the 180 days. So this is a very strict timetable. So a lot of investors who sell out of that original property, they’re highly motivated to identify a replacement property with that 1031 exchange, and honestly, it can be a lot of pressure. It can be a little bit stressful, especially in those last few days of the 45 days, and in those last few days or few weeks of that 180 days can be very stressful, which I think is a benefit, Jimmy, of the DST vehicle. But we’ll get to that in a minute.
Jimmy: Yeah, absolutely. If you don’t mind me interjecting here for a moment, I wanna rewind to the tax benefits that you were talking about earlier. Essentially get to defer capital gains indefinitely when you continue to exchange properties through this 1031 exchange, a section of the Internal Revenue Code. And importantly, when the taxpayer eventually passes away, his or her heirs receive a step-up in basis equal to fair market value which essentially means that it wipes away the capital gain forever, which is a huge benefit to that taxpayer’s heirs at death.
Andy: Absolutely. Yeah. So the 1031 exchange in and of itself is an amazing vehicle that if you’re investing an investment in real estate, you probably already know about the 1031 exchange, right? It’s a great deal. However, and I guess this is bringing us to our next section of today’s episode, it’s not always ideal, right? Because as I talked about, at the end of that 45 days or 180 days, it could be very stressful.
What if an investor hasn’t found the right property or maybe it’s not even the timing that’s an issue, at least short-term timing, what if you zoom out? And we’re talking about an investor who’s actively managed real estate for their entire career, but they’re at or nearing retirement age, and they wanna get out of the game. They don’t wanna have to deal with the 3Ts anymore and that’s where the Delaware Statutory Trust comes in. It can be a very attractive vehicle for that type of investor.
Jimmy: Yeah, absolutely. It offers an investment vehicle that allows for just more passive type of investment where, as you say, you aren’t dealing with the 3Ts, tenants, toilets, and trash. Maybe you wanna just kick up your feet and relax, and not worry about actively managing a 1031 exchange property or possibly also it kinda helps with those timing requirements that you were speaking about, Andy.
If you get toward the end of your 45-day timeline where you can’t quite identify the property in time or maybe the transaction fails within that 180-day transaction timeline, there’s plenty of DSTs available that are open to investment and those can be lifesavers. And then by the way, just a little sneak peek, we are going to preview another alternative form of investment called the Opportunity Zones toward the end of this episode and into the next episode which offers a different type of alternative. But I’ll save that for a little later on. But turning back to the main alternative, to a 1031 exchange, the DST, what today’s episode is intended to be all about, Andy, what is a Delaware Statutory Trust?
Andy: Good question. And you said it’s an alternative to a 1031 exchange. But I think technically we should say it’s a type of 1031 exchange, right? Because the DST actually qualifies as a replacement property under the 1031 exchange mechanism. But it’s a specific type of replacement property. So a DST, it stands for Delaware Statutory Trust, it’s an investment vehicle that organizes a trust that generates passive income from real estate for the investor. So in 1988, the State of Delaware passed the Delaware Statutory Trust Act which along with the subsequent IRS ruling allowed DSTs to be used as replacement properties under the 1031 exchange rules.
So the DST is a trust that’s run by a sponsor, meaning that the investors in the DST will not be actively involved in the operations of the investment, right? So that’s totally different from a traditional 1031 exchange where you sell a building, you take the proceeds and invest them into a new building that you yourself own and actively manage, right? With the DST, it’s fractionalized. So the trust will be offered to multiple investors who are pooling their money together and then the sponsor is taking care of the administration and the financing, and then hiring out for management, or doing it themselves. They’re managing the property. So all of the investors are passive. So it utilizes the 1031 exchange vehicle, but it changes the dynamic where the investor is now a passive owner in a trust.
So again, DST is not appropriate for everyone. It’s appropriate for a very specific type of person which is someone who wants to utilize the 1031 exchange mechanism, because they either are sitting on a large capital gain from the sale of an investment real estate property or they have one that’s upcoming. However, they’re not interested in actively managing the replacement property. That’s where the DST is a slam dunk. There are a lot of rules and regulations concerning DSTs that the sponsor has to follow. So they’re very much scoped and fairly predictable investments. In the world of real estate, I would say DSTs are fairly predictable, fairly stable, and there are some reasons for that that I can get into here, Jimmy.
Jimmy: Yeah, yeah, certainly. Well, first, I wanna hear about those rules and regulations that the IRS has written on DSTs. I believe they’re referred to as the seven deadly sins. Can you talk about those a little bit?
Andy: Sure. And along with the seven deadly sins which I’ll get to in a moment, I should also say that a person generally must be an accredited investor to invest in the DST. So right off the bat that’s another qualifier, but then the IRS has issued specific regulations concerning the management and operations of the DST by the trustee. So colloquially these are known as the seven deadly sins, and I’m just gonna run through those briefly. I don’t think it’s important to necessarily know all the ins and outs if you’re just getting started looking for a DST, but definitely if you’re gonna be making an investment into one, it’s important that you do due diligence, do research, and learn more about these.
So first, rule number one, once the initial DST offering is closed, investors may not make any new capital contributions, right? So typically this risk will be mitigated by ensuring that there are quite high capital reserves in that initial race.
Secondly, the DST’s trustee may not renegotiate the terms of existing loans nor may borrow new funds except under very limited circumstances. So the investors in the DST like, they know what they’re getting into in terms of the loans.
Thirdly, the DST’s trustee may not renegotiate current leases nor may enter into new leases unless there is a tenant bankruptcy or insolvency. So a lot of times the DST will enter into a long-term lease contract with an affiliated entity to operate a property at the time that it’s required. So this is known as a master lease. So that’s kind of a, I don’t wanna say a way around that rule, but it’s a way to deal with that rule.
Number four, upon the sale of a property owned by a DST, those sale proceeds must be distributed to the investors, right? And then those investors if they want to, they can do a subsequent 1031 exchange. However, the trustee may not use the sale proceeds to acquire a new property within the DST, right? So Jimmy, already we’re kind of seeing with these rules, the trustee is sort of like, wearing handcuffs, right? They’re tightly regulated in terms of what they can do with the funds that they raise.
Number five, a DST’s cash reserves may only be invested in short-term debt obligations rather than anything more speculative, right? And again, the DST will often have pretty high cash reserves because they’re not able to do those subsequent rounds to raise additional capital.
Number six, any cash accrued within the DST in excess of the required reserves must be regularly distributed to the investors, and these distributions are usually done on a quarterly basis. So again, we’re not accruing cash within the fund so that the trustee can do something speculative with it or, you know, acquire a new property or anything like that. Again, they have these handcuffs.
And number seven, lastly, the trustee of a DST may not make significant improvements to a property, right? And this is the big one. This is sort of a bit of an outlier with real estate. So capital expenditures are limited to, A, normal repair and maintenance, B, minor nonstructural capital improvements, and C, you know, any improvements that are required by law.
So when you take these rules, these seven deadly sins as a whole, we’re looking at a very specific type of investment that in the world of real estate investments is actually going to be pretty predictable and pretty stable.
Jimmy: That’s great, Andy. Thanks for running through those. So DST is a very specific type of 1031 exchange, and there’s a lot of similarities between a DST and I would refer to it as a more traditional 1031 exchange or direct investment through a 1031 exchange. What are some of the similarities and differences between these two different types of investment vehicles?
Andy: Yeah, good question. Well, they both are a type of 1031 exchange, right? So in either case, the investor is realizing those benefits of deferring their capital gain. So that’s a similarity, but with the DST, first of all, the investor needs to be accredited, right? So right off the bat that’s gonna rule out a lot of folks from investing in a DST.
Secondly, I just think that the passive and fractionalized nature of the DST, it’s more like a fun. When you own a share of a mutual fund or you don’t have a vote on how to run the fund or anything like that, as opposed to when you go out and buy an apartment building or multifamily housing property, and you’re the sole owner, you have all of the control, but you also have all of the responsibility. So I really think that’s a qualitative difference between the traditional 1031 replacement property versus the DST, but they both have those exact same tax benefits.
Jimmy: So yeah, that fact that you have to be an accredited investor, that’s one big difference. But just a quick definition of what an accredited investor is in case you don’t know, there’s a few different requirements to achieve accredited investor status. But the two main requirements that most people usually pass through is, one, you have to have a net worth of at least $1 million dollars and that excludes your primary residence or, two, you have to have income of at least $200,000 annually for each of the past 2 years, or $300,000 annually if you file jointly with a spouse.
So those are the two main hurdles to become an accredited investor. Some other differences between the two, one, I would say that 1031 exchanges or a traditional directly held 1031 exchange property are oftentimes more liquid, right? Because you’re the only investor in it and you can choose when to sell it. It’s not as liquid as cash, obviously, or something that trades on the public market, but, you know, you can sell a property and get cash back for it within a few weeks typically, whereas with a DST, you’ve got a much longer holding period. Is that right, Andy? What’s a typical holding period look like for a DST and can you get money out of it ever if you’re just one of several dozen or hundreds of investors?
Andy: So a typical lifecycle for a DST is 5 to 10 years, right? So that’s quite illiquid and, I mean, an individual property, a direct investment in real estate I would already say is fairly illiquid when you’re comparing it to traditional investments like, stocks and bonds. But the DST is all the way at the other extreme, right? That’s why it’s an alt. It’s very illiquid when you’re talking about a 5 to 10-year holding period. Depending on the DST in question, there might be a buyback program, but those terms are not going to be very favorable to the investor. You’re typically gonna take a haircut, you know, if you avail yourself of that buyback program. So you really should plan on holding on to the DST for 5 to 10 years before the liquidity event.
And so the DST is highly illiquid. And, you know, another thing, Jimmy, in those seven deadly sins, you don’t have the ability to raise new capital for significant property improvements, right? So DSTs, they tend to purchase more stable properties that maybe have less downside that have, like, a long-term lease contract with a rock solid tenant. But on the other hand, they tend to have less upside for that very reason, whereas with a traditional replacement property, the world is your oyster, right? You can do whatever you want. You could purchase a replacement property with the traditional 1031 exchange that is very stable with less downside, but also a limited upside.
But you could also invest in a property that was highly risky that needed a ton of property improvements, but that also had much more upside. So I think investors in the DST, typically, they’re looking for income and return of capital. They’re not necessarily, you know, looking to hit that grand slam double digit annual returns with their capital. And again, that goes back to a typical DST investor, if someone who maybe has actively managed real estate property in the past, but is ready to go passive. And oftentimes, they’re nearing retirement age, right? So sort of makes sense that the DST vehicle, we tend to own these more stable properties with a focus on consistent income and return of capital, but less focus on upside.
Jimmy: Yeah. No, that’s a good point, Andy. That’s a really good distinction there. Oftentimes you’re able to with the DST gain access to institutional-grade properties that you might not be able to as a smaller investor. Since you’re essentially pulling your money with dozens if not hundreds of other investors in the DST, you can gain access to much higher value properties, healthcare facilities, or you mentioned leased properties. You know, I’m thinking of a strip mall or potentially sometimes a portfolio of strip malls that are triple net lease type properties with anchor tenants like CVS, Walgreens, Dollar General, those types of companies that are your anchor tenant and provide you with stable income for years and years. More plain vanilla deals, I guess, in some sense, but they’re more reliable. They’re gonna hit base hit after base hit for year after year. Is that right?
Andy: That’s exactly right.
Jimmy: Good. So let’s talk now about some of the advantages and the disadvantages of DSTs. We’ve mentioned a few of these properties of DSTs already, but maybe we can go through them through the lens of whether a DST is advantages or sometimes disadvantageous. Andy, can you walk us through some of those advantages and disadvantages?
Andy: I sure can. And a lot of them, to be honest, are double-edged swords. And different investors with different objectives may look at the same aspect as a disadvantage or as an advantage, right? So right off the bat, I think this one is a true advantage, right? The DST vehicle because you’re pulling together so many investors, a DST can purchase real estate properties in the 100 million and up price range, right? So institutional-grade real estate and that class of real estate just typically is not available to an individual investor unless they’re literally a billionaire. So just access to a different grade of real estate I think is an advantage to the DST.
Secondly, another potential advantage is the fact that investors are passive in the DST. Some investors might prefer to have actively managed a property. In that case, the DST won’t be appropriate for them, but for an investor who’s at or nearing retirement who doesn’t wanna actively manage a property anymore, the DST offers a wonderful advantage where you can still swap into a new property which is the DST, but going entirely passive.
I’d also say another advantage of the DST is diversification. So a single Delaware Statutory Trust could own multiple properties which, again, that’s something that an individual investor might not be able to access depending on their budget. And then, lastly, that focus on income and return of capital, the relative predictability of the DST due to the fact that it’s so highly regulated, the seven deadly sins, that means that it’s gonna be a pretty predictable vehicle for an investor to put their funds in.
And that brings me to the disadvantages of the DST. So I do think the illiquidity, we have to say it’s a true disadvantage. I mean, compared to owning an individual property which if you own a property, you can sell it and realize a capital gain anytime you want, whereas if you’re locked into a DST, it most likely is going full cycle within 5 or 10 years and it’s very illiquid. Your ownership is very illiquid during that time period.
And then I think the other two disadvantages I’d mentioned, well, the relative predictability also means that there’s limited upside, right? So there’s that double-edged sword. And then, lastly, the fact that it’s passive, again that totally depends on the investor. A lot of real estate investors, they like having control over the property and especially in terms of the decision making ability on when to sell, when to lock in a capital gain. So the passive status of an investor, you know, it’s a double-edged sword.
Jimmy: No. Those are great points there, Andy. I agree, the passive is a double-edged sword for sure. Probably one of my favorite advantages is that diversification aspect, the ability for an investor who may have only had one property can now sell that property and diversify across multiple properties through a couple of different ways.
One, he or she can invest in a multiproperty DST. A lot of DSTs do just hold a single property, but there are some DSTs that hold 3 or more property, sometimes 10, sometimes up to 20 or more properties, which really gets you access to a lot of diversification, not only across different property types, but across different geographies as well. And then the other way that an investor could potentially take their 1031 exchange property and diversify into multiple properties is he or she is also able to invest into multiple DSTs as well. So a couple of options there for the investor.
So Andy, our listeners now, maybe they realize that they already have a 1031 exchange and they’re considering, well, should they do a traditional replacement property 1031 exchange if they’re ready to get out of their current property or should they look at a DST structure instead? How do I know DST is right for me?
Andy: That’s a good question. And I actually love that question because I think the answer is pretty clear cut, right? A DST is potentially a good fit for an investor who, number one, is an accredited investor, right? So that’s like, an easy yes or no hurdle.
Two, has recently sold or plans to sell real estate property for a significant capital gain.
Three, is not interested in actively managing the replacement property. Again, you’re gonna know either way if you wanna go passive or if you wanna actively manage your next property.
Four, if you desire the diversification or the focus on capital preservation in income rather than looking for a more speculative or property with a potential for very high capital appreciation.
And then, lastly, you need to be comfortable with that investment lifecycle of 5 to 10 years. You need to be comfortable with illiquidity. And that really goes back to the need to be an accredited investor, right? I wouldn’t recommend that someone put 80% of their net worth into a single DST for instance.
Jimmy: Yeah. That would probably always be a bad idea. You don’t wanna put that many eggs in one basket, right? So Andy, where can our investors or anyone listening potentially find DSTs? I wanted to talk about that for a minute before we sign off for today’s episode. So there are dozens of DST sponsors that are actively raising capital for their DST funds nationwide and, typically, they have fairly low investment minimums for someone who’s an accredited investor and who is exiting from a property where they may be accruing a six or seven figure gain on it.
Oftentimes, the investment minimums are as low as $25,000, sometimes $50,000 or $100,000. I have come across a few that have even lower minimums of just $1,000. So you can really slice and dice, and get access to a lot of different DSTs with fairly low amounts, relatively speaking. And we’re gonna have links to some resources where you can learn more about DSTs and learn more about different DST sponsors on the show notes for today’s episode. You can find those show notes at altsdb.com/podcast.
Andy: And Jimmy, before we jump off, I have to give a plug for our next episode because I imagine we’ll have some listeners who are saying to themselves, “Well, the DST sounds great, but I’m actually sitting on a large capital gain that is not from the sale of investment real estate, but is from the sale of private stock or a publicly traded stock, or bonds, or just any other type of capital gain.”
Jimmy: Or Bitcoin, right?
Andy: Right, right. And so, I do think DSTs… By the way, DSTs are fantastic when they’re appropriate. I think they’re an awesome vehicle and especially for their tax advantages. But they’re just not applicable to a large number of investors. So the next investment vehicle we’re talking about in episode 3 is the Qualified Opportunity Fund, and that is an investment vehicle that’s gonna be applicable to a wider group of investors because it can give you tax advantages for any sort of taxable capital gain that you’re sitting on or that you have coming up soon. So I don’t wanna give too much away, right? Because I wanna save a little for the next episode, but I’m really excited to talk about that on our next Ep.
Jimmy: Yeah. I’m looking forward to it as well. And it could also be a good vehicle for anyone who’s blown through their 1031 exchange timeline as well depending on some of their unique facts and circumstances. I’ve seen that come through for blown 1031s as well, but we’ll save all that good stuff for episode number 3. Andy, it’s been a pleasure talking with you today. Thanks, buddy.
Andy: Thanks Jimmy.