Last updated on April 18th, 2020 at 05:07 pm
Most folks talk about the three terrible T’s of real estate investing – tenants, toilets, and trash. We happen to think there’s more terrible T’s than just three.
Telephone calls… (usually at 3 AM about something that could have waited until the morning)
You get the point. Real estate investing is a rewarding field, but it has its own share of headaches. Now that you know more about the 1031 exchange, you’re likely wondering how to buy a truly passive investment as your replacement property. The 1031 exchange DST (Delaware Statutory Trust) is a fantastic way to improve cash flow, your quality of life, and get rid of the terrible T’s.
What is a 1031 Exchange DST and Why Would I Use It?
The Delaware Statutory Trust (DST) is a real estate investment structure that allows a large number of investors to purchase small pieces of real estate. The reason they’ve exploded in popularity is that they allow deferral of capital gains and depreciation recapture if you’re doing a 1031 exchange DST. This is because DST’s qualify as “like-kind” investments following a 2004 IRS Ruling. Any investment or business property you own is considered “like-kind” to any 1031 exchange DST property!
Almost all 1031 exchange DST properties are truly passive investments. They typically are offered by a sponsor who puts in place a management team to run the day-to-day tasks associated with the DST property. This is another reason the 1031 exchange DST model has skyrocketed in popular. Real estate investors who are tired of tenants, trash, toilets, and more can do a 1031 exchange with a DST as their replacement property.
Many DST properties are also NNN (Triple Net) retail or office properties. A NNN property is where the tenant is typically responsible for property taxes, maintenance costs, and insurance. Many real estate investors who are wondering what is a 1031 exchange DST are pleasantly surprised when they find this model.
How Are DSTs Different Than TIC Investments?
You may be wondering how a DST differs from TIC investments that were previously popular. For the most part, these structures are extremely similar. The biggest difference is that DSTs are not limited to 35 investors in a single deal. This helps by lowering the investment minimum to $100,000, and sometimes as low as $25,000.
Another advantage is that the lender makes one loan to the DST sponsor, rather than separate loans to each investor. Under the TIC structure this caused immense confusion and internal struggles.
The last major difference between DST and TIC investments is that under the DST structure, each investor is given no vote or say in the operations of the property. While this may sound like a bad thing, it helps to keep the investment on track and under good management. This makes it even more critical to choose a DST sponsor wisely and after thorough due diligence.
How Does a DST Delaware Statutory Trust Work?
Usually, a DST is set up by a real estate sponsor who then names trustees to manage the assets of the trust and the overall business. A sponsor is an individual or company that is in charge of finding and acquiring the real estate property on behalf of a partnership, such as the DST. A trustee has a fiduciary responsibility to the beneficial owners (i.e. the investors in a DST property).
The trust is ultimately who collects the investment money, arranges financing, and hires property management companies for the property. It’s also the trust itself that directly owns the asset, and individual owners are the ones who own a share in the trust.
A Delaware Statutory Trust is similar to an LLC in that all income and dividends are passed through and taxed on the individual’s level, rather than the group level. The advantage of the trust model over an LLC is that it is much simpler and cheaper for a sponsor to create and operate. The DST model still retains the “limited liability” advantages of an LLC. This is the background on how a DST works and why it’s chosen by real estate sponsors.
What Are Some Real Estate Investments Properties for the 1031 Exchange DST?
Although NNN (Triple-Net) properties are most common for a 1031 exchange DST, all other types of properties can be packaged as a 1031 exchange DST. This means apartment buildings, self-storage, offices, and healthcare centers can all be purchased through a DST. The DST is a structure that is similar to a limited partnership or LLC. The difference is that a DST is considered a security and able to be used as the replacement property in a 1031 exchange.
In order to access 1031 exchange DST property listings, you’ll need to use a securities broker/dealer. Additionally, many of these brokers are only able to offer DST properties to accredited investors.
The type of DST property to purchase ultimately comes down to your goals. Generally, residential DSTs such as apartment buildings are considered safer and produce a lower yield. Retail or office DST properties are considered to be higher risk, so they tend to have a higher yield. That said, each DST is different and has a different risk profile. By working with a broker, they’ll be able to identify your goals and recommend products that meet those goals.
How Much Leverage or Financing is Used in a 1031 Exchange DST?
A large advantage of the 1031 exchange DST structure is that there’s varying degrees of leverage used in different deals. By contacting a 1031 exchange DST broker, they can put you in front of properties that use no leverage, some leverage, or lots of leverage. Since IRC Section 1031 states that you must take on “equal or greater debt” with your replacement property, some investors need to use leverage in their 1031 exchange DST. More risk averse investors can find 1031 exchange DST properties that use little or no leverage, which may be a positive depending on your goals.
Another advantage of 1031 exchange DST properties is that the financing is almost always “non-recourse” as an investor. This means that the collateral on the loan is the property itself. As an investor, this means that you do not need to qualify for a loan or offer up a personal guarantee of your existing assets. The property itself serves as the collateral on any 1031 exchange DST financing.
This non-recourse financing is usually long-term (seven to twenty years) and locked in place before the 1031 exchange DST property goes to market. This reduces the risk that you go over the 45-day identification period. If you purchase a DST property that has leverage, you will usually receive a pro-rated portion of the principal pay-down. This means you’re building equity in the property and is another great advantage to the 1031 exchange DST.
What Happens when a 1031 Exchange DST Property is Sold?
One of the most important things investors want to know if what happens when the DST property you own is sold. More specifically, investors want to know if they are allowed to do another 1031 exchange and defer capital gains tax again. The answer is a resounding yes, and this is a huge advantage of the 1031 exchange DST structure.
Since there can be years between buying into a DST property and selling it, you would expect there to be capital gains accumulated on the property. A DST property is considered like-kind to any other type of real estate. With the DST, you’re able to roll-over your equity into another DST, or even another real property. If for some reason you don’t want to buy into another DST, you could take your equity and capital gains, and purchase a residential or commercial building. This makes the 1031 exchange DST an extremely powerful tax-deferral tool.
What are the Pros and Cons of 1031 Exchange DST Properties?
Like any kind of investment, there are pro’s and con’s to using a DST property for your 1031 exchange. Before engaging with a broker/dealer who can sell these properties, you should be aware of the risks they may or may not disclose to you.
Advantages of 1031 Exchange DST Property Investments
- No Hassle Property Management – One of the most attractive aspects of the 1031 exchange DST structure is that property management is always outsourced to a third party firm. Not only do you not need to manage the properties yourself, you don’t even need to manage the property manager. The DST Sponsor is responsible for arranging all asset management, rent collection, bookkeeping, repairs, etc.
- Minimum Investment Flexibility – DST structure allows you to invest a smaller amount of money than is typically possible with traditional real estate investments. Usually these minimums are around $100,000, although many DST sponsors allow minimums closer to $25,000 now. This can be extremely useful if you’re doing a partial 1031 exchange. The leftover funds (after buying a replacement property) can be redeployed to a DST in order to avoid “boot” that is taxable.
- Meeting Exact Equity and Debt Needs – In a 1031 exchange, you must redeploy all the equity in your existing property to your replacement, and any debt needs to match as well. This can make finding a replacement property that has specific characteristics tough to do. The 1031 exchange DST property type makes it easier to find a property that meets your exact debt and equity needs.
- Institutional Grade – The DST is one of the best ways to get exposed to higher quality properties in the $25M-$125M range. Rather than owning single-family homes, you can own large investment properties that are occupied by Fortune 500 and other AAA credit tenants. Some of these properties include apartment complexes, grocery stores, healthcare facilities, and other properties usually not available to everyday investors.
- Diversification – Rather than deploy all of your equity into a single replacement property, with DSTs you can buy pieces of multiple properties. This is especially useful if you’re looking to do a 1031 exchange on one large property, and diversify into multiple replacements.
- Non-Recourse Financing – Loans will already be in place using the work of the DST Sponsor. For real estate investors who have built up equity in a property and want to reduce risk, the DST is attractive because the financing is not a personally-backed loan. In almost all DSTs, the property itself serves as the collateral for the loan.
- Readily Available – Much like the flexibility a DST property offers in meeting exact equity and debt needs. Many investors choose DST properties because they are always available. For investors coming up against their 45-day identification and 180-day closing timelines, DSTs can be extremely useful.
Disadvantages of 1031 Exchange DST Property Investments
While the DST represents a fantastic option for many real estate investors, there are still some drawbacks to be aware of. Some DST brokers may not alert you of all of the risks and disadvantages of the DST model.
- Illiquid – Similar to other real estate investments, DST properties are considered illiquid. Especially in comparison to stocks, bonds, or other publicly-traded investments, it is hard to sell an existing DST investment. DSTs are long-term investments, with an expected investment period between five and ten years. Some DST brokers have started offering a “DST Secondary Market” though these are still nascent.
- Lack of Control – Unlike owning real estate outright, there is a lack of control in what happens to the property. The 2004 IRS ruling that made DSTs a suitable 1031 exchange replacement property stipulated that investors cannot have any type of control over their DST properties. This is a major advantage DSTs have over the older TIC properties, where there were issues between property owners.
- Can’t Raise New Capital – Also owing to an IRS ruling, once a DST offering is closed there cannot be any more contributions. If the property needs additional capital expenditures like a roof or HVAC system, this can eat into profits you’ve earned in previous years.