Delaware Statutory Trusts for §1031 Exchange Replacement Property
May 11, 2023 1031 exchange,brooklyn,brooklyn real estate,Brooklyn Sellers Agent,real estate taxes,taxes
By Barry Neustadt, CPA, Tax Director, Madison 1031
Madison §1031’s exchange clients are often challenged face to find a suitable Replacement Property within the tight 45-day identification period. We hear about cap rate compression from nearly every investor. Then, when they find a property, they still need to negotiate an acceptable price and complete their due diligence and close according to the timeframe stipulated in the Contract. And, if the property they identify doesn’t work out, they cannot complete their §1031 Exchange.
One solution for taxpayers is the Delaware Statutory Trust (“DST”). A DST is an Investment Trust or Land Trust that is usually formed under Delaware state law. The DST acquires institutional grade real property to be held as a passive investment. Assuming the DST is structured correctly in accordance with Revenue Ruling 2004-86, a taxpayer may acquire a beneficial interest in a DST as Replacement Property for their §1031 Exchange. For tax purposes, the transaction is seen as the acquisition of a fractional or partial interest in the underlying property, similar to acquiring a Tenant-In-Common interest with other investors.
DSTs are sophisticated investments, and to invest in one, the individual must be an accredited investor. Therefore, these investments are limited to higher net worth individuals.
The Benefits of a DST
Assuming the taxpayer qualifies, a DST offers several advantages over other types of real estate investments:
- Availability – At any given moment, the various sponsors offer many DSTs in a variety of marketplaces and in almost every real estate sector. Taxpayers faced with the impending expiration of their 45-day Identification Period can often identify one or more DSTs even at the last minute. Additionally, closing on a DST interest can happen very quickly and most often well within the 180-day Exchange Period.
- Diversification – Since DSTs are available in many different regions and market segments, by acquiring DSTs taxpayers can invest outside of their local region and purchase property in a different market segment. For example, a taxpayer might exchange a six-family rental house in Brooklyn and buy a DST interest in an office park in Silicon Valley and another DST interest in a hotel in Orlando.
- Freedom from Management – Properties held by a DST are managed by the Trustee or an affiliate of the Trustee. As a result, taxpayers acquiring DSTs can escape the management headaches of the “Three Ts”—tenants, trash and toilets! This can make DST’s appealing for a taxpayer looking to retire from active management but allow them to stay invested in real estate, while still deferring taxes via §1031 Exchange.
- Institutional Grade Property – By acquiring a fractional interest in a large property, taxpayers can invest in much larger and more expensive properties than they could otherwise on their own.
- Investment Matching – DST properties allow the taxpayer to match the equity and debt requirements more precisely in acquiring real property of sufficient value to defer fully any gain. So, if they sold their Relinquished Property for $1 Million and paid off a $500,000 mortgage, they could acquire a DST investment for similar equity and debt. Additionally, since the Trust is the borrower for the mortgage on the property, the taxpayer does not need to obtain a separate mortgage, and the financing is non-recourse to the taxpayer. Additionally, taxpayers can often assume higher levels of debt, allowing them to acquire an even larger interest in the DST.
The Drawbacks of a DST
Despite its many advantages, prospective investors should be aware of the drawbacks of a DST. It is important to note that DST investments are still real property. As such, they are subject to the same market risks as other real property investments. Like many other real estate investments, DSTs are also not liquid. Typically, the taxpayer should plan to be invested in the DST for five to seven years and maybe even as long as 10 years, which are the typical timeframes in which the underlying real estate would be sold allowing the taxpayer to either recognize their gain or acquire another Replacement Property through a §1031 Exchange. The investor does not have control as to when the asset will be sold. Additionally, they generally cannot sell their share to someone else if they need to free up capital.
Acquisition and management costs for a DST may also be higher than your typical real estate investment, so it is important to ensure that the anticipated returns justify the expenses. Some of the very high loan-to-value DSTs offer very attractive values to satisfy your §1031 Exchange. However, the property may not have enough cash flow due to the high mortgage. Ultimately, the property may incur phantom income – where taxable income is created without distributions to cover the tax expenses. Lastly, as there are many DST sponsors and properties available, due diligence is still a necessity before selecting any investment.
As it can be complicated, the exchange experts at Madison 1031 are available to guide you through the exchange process, whether it is for a DST or another type of replacement property that interests you.
Barry Neustadt, CPA is Tax Director of Madison 1031. He assists clients in all matters of §1031 Exchanges, and guides their attorneys and accountants on advanced tax-compliant solutions. Barry was a Tax Manager with RSM prior to joining Madison and has broad tax and real estate expertise.
Madison Exchange, LLC is a leading Qualified Intermediary handling all types of §1031 Exchanges while ensuring security of funds through Express Trust accounts, FDIC-backed accounts, a $40 million Fidelity Bond, $10 million E&O policy, and Dual-Signature accounts.
Pat Anarumo, Vice President of Sales
Madison Commercial Real Estate Services
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