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A Delaware Statutory Trust, or a DST as it is commonly referred to, is a tool property owners use to accomplish a 1031 Exchange. A DST is a legal trust structure created under Delaware law designed to qualify as a replacement property as defined in IRS Revenue Ruling 2004-86.

A DST usually has the following components as part of the legal structure: a trust document, a trustee, a master tenant, beneficiaries, and the property.  While the DST structure with all its different named legal parties can sometimes be daunting to follow, it can be boiled down to several familiar positions.

  • The Sponsor of the DST, who may also be the trustee, or they may have an affiliated company be the trustee, purchases the property and is responsible for making it a DST. The equivalent of this entity in a personal real estate transaction is you.
  • The tenant is the entity occupying the property. It is the same when you purchase a property and find someone or some company to rent the space.
  • The Master Tenant is the entity that is responsible for the property management, collection of rent, and leasing to the tenant. In a personal real estate transaction, this is usually done by a property manager.

Once a DST is created and has gone through the extensive due diligence process, it is made available for investment to the public. The DST owns the underlying real estate and an investor, called a Beneficial Owner, owns a percentage of the overall DST. For 1031 exchange purposes the IRS views the investor as owning the real estate directly, but for all other purposes, the investor is a passive participant. This means that no investor has the authority to direct any action, legal or otherwise, of the DST, thus protecting every investor from another investor’s actions.

[If an investor is participating in a 1031 exchange, please follow the IRS rules to qualify.]

As mentioned above, the investor owns a percentage of the DST which means they receive a portion of the net income, tax deductions, and appreciation or value loss on the property. Some of the benefits of a DST over personal real estate are the following:

  • The opportunity to own high quality, investment grade real estate such as shopping centers, industrial properties, office buildings, etc., which can generate cash flow from national tenants.
  • The opportunity to receive cash flow without the work of finding, acquiring, and managing the property yourself.
  • Avoidance of the 4 “T’s” – toilets, tenants, trash, and telephone calls.
  • Limited personal liability – and loan on the property is non-recourse which means the beneficial owners are not personally liable for the debt.

As beneficial as a DST may be for an investor, you also need to be aware of the fees and risks.  These are disclosed in the DSTs private placement memorandum. There are typically acquisition fees, management fees, and DST expense fees. Risks are similar to owning real estate personally such as changing markets, tenant vacancies (no incoming rent for income), and tax law changes. A DST also has the risk that the trustee will perform as expected. As with personal real estate, there is also no guarantee that the value of the DST will increase.

At the end of the day, an individual interested in doing a 1031 exchange should investigate a Delaware Statutory Trust as a possible investment. Understanding the benefits and risks are essential before deciding to invest. However, if you are ready to stop being a landlord and relinquish the day-to-day management, would like some diversification, and yet still own real estate, a DST may be right for you.

The term “Like-Kind” pertains to the category, and not the specific type, of asset that qualifies for 1031 tax-deferred treatment. Gain on the sale of assets categorized for investment purposes that are used in a trade or business can be sold and the gain can be deferred if new assets are purchased to replace the assets that were sold, and all 1031 rules and regulations are met.

This can cause confusion, as some investors might think “Like-Kind” means if you sell a specific asset held for investment such as a commercial office building, you must purchase a commercial office building to meet IRS 1031 tax-deferred exchange “Like-Kind” asset requirements. But this is not true. Any asset in the “Like-Kind” category will qualify as a suitable replacement property.

For example, a single family rental can be exchanged for raw land, or apartments or a commercial building.

In addition, properties can be exchanged anywhere within the United States. In addition, “Like-Kind” property can include Tenant-In- Common (TIC) and Delaware Statutory Trust (DST) real estate investments.

No, a 1031 tax-deferred exchange can be completed as a simultaneous exchange meaning one asset is sold and a new asset is purchased in the same transaction, a delayed exchange meaning Property One is sold first and Property Two is purchased later, or a reverse exchange meaning that Property Two is purchased first and Property One is sold later.

API comments that the majority of current 1031 tax-deferred exchanges are completed using the delayed format.

You have to decide to implement a 1031 exchange before Property One is sold. This means that you must establish your 1031 account with a Qualified Intermediary before you close escrow on the property you are selling. You cannot close escrow on your property today and then decide tomorrow to implement a 1031 tax-deferred exchange.

Adhering to the time requirements of Internal Revenue Code Section 1031 is extremely important. Important 1031 tax-deferred exchange dates are all calculated from the date Property One closes escrow:

  1. From the date Property One closes escrow, you have a maximum of 45 CALENDAR DAYS to name the next property, Property Two, you plan to buy.
  2. From the date Property One closes escrow, you have a maximum of 180 CALENDAR DAYS to close escrow on Property Two that you named in the initial 45-day period.
  3. In some cases, sellers may not receive the full benefit of the entire 180 days if the due date for their tax return in the year following the sale occurs prior to the end of the 180 day period. In that case, the taxpayer would need to file an extension in order to have the benefit of the full 180 days.

To receive a full deferral of income taxes, property Two must receive 100% of the net equity proceeds that came out of Property One. The sales proceeds for Property One must go from the title/escrow company directly to your Qualified Intermediary. You must not receive any funds from the buyer of your property or from the title/escrow company. Funds you receive are “boot”, and are generally subject to income taxes.

It is important to understand that receiving funds from the sale of Property One does not invalidate your 1031 tax-deferred exchange, but it will potentially subject the amount you receive to income taxation.

Property Two must cost at least as much as much as what Property One sold for. To benefit from 100% income tax deferral, you cannot “trade down” from Property One into Property Two. The IRS allows full tax deferral only if you buy a replacement property of equal or greater value. “Trading Down” to a lower priced Property Two does not invalidate your 1031 tax-deferred exchange, but it will potentially subject you to income taxation on the decreased cost of Property Two as compared to Property One.

Property Two must have at least as much debt as Property One unless you pay down the new debt with extra cash. Having less debt on Property Two does not invalidate your 1031 tax-deferred exchange, but it will potentially subject you to income taxation on the decrease of debt on Property Two as compared to Property One.

A 1031 tax-deferred exchange is tax-deferred, it is NOT tax-free. It is important to understand that although income taxes can be deferred currently on the sale of Property One, when Property Two is sold in the future there could be income taxes to pay at that time. It is also important to understand that when Property Two is sold at some time in the future, income taxes on the gain from the sale of Property Two could be higher, and reduce or eliminate the income tax benefits from the sale of Property One.

It is very important to understand that there are many costs related to selling Property One, buying Property Two, and in executing a properly structured 1031 tax-deferred exchange. These costs must be carefully reviewed and studied because these costs could easily surpass any income tax benefits a seller of real estate could receive in a 1031 tax-deferred exchange transaction.

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