Delaware Statutory Trusts for 1031 Exchanges
We’ve written in another article about how 1031 exchanges provide taxpayers the opportunity to defer taxes due upon the transfer of a property. We’ve also discussed how tenancy in common structures can sometimes facilitate 1031 exchanges. Here, we discuss another approach, the use of Delaware statutory trusts.
Several significant challenges exist for successfully completing a like-kind exchange under Section 1031 of the Internal Revenue Code.
In certain circumstances, beneficial owners of a Delaware statutory trust (DST) that owns real estate will be treated as owning a direct interest in such real estate for purposes of Section 1031. This determination will be very fact-specific, but generally requires the following:
This point is crucial; the manager/trustee must have very limited powers; in the real estate context, this means that it can NOT:
The lessor must make a minimum, unconditional “at risk” investment in the property that remains throughout the lease term. No member of the group of sub-lessees may have an option to purchase the underlying property at less than its then-current fair market value. No member of the group of sub-lessees may make acquisition loans or guarantees. The lessor must expect to make a profit from the transaction (apart from tax deductions and credits).
Owners cannot transfer cash to the trust for reasons other than for a purchase of an interest therein.
Creditors of beneficial owners in a DST cannot assert claims directly against the property held by the DST; those owners are entitled to the same personal liability limitations from the DST’s actions as apply to a corporation’s stockholders; a DST may sue or be sued as an entity, and can be formed for investment purposes. These powers and privileges have led the IRS to conclude that a DST is an entity separate from its owners for Code purposes.
There are other requirements, but a properly structured DST generally meets those. If all the requirements are met, then, as “grantors,” owners of a DST should be treated as owning an undivided fractional interest in each of the underlying properties and thus eligible for 1031 exchanges.
There are clearly some drawbacks to DSTs that make them unsuitable for some 1031 exchanges.
The pre-packaging, trust structure, and property management limitations makes a DST a truly passive investment with very limited input from investors.
These investments are usually designed for long-term holding periods, usually 5-10 years; a DST is thus not suitable for an investor who just wants a place to temporarily “park” his money while waiting for some other investment to come along.
Individual investors that have managed their own properties may also be used to better than the 6%-7% annual income that many DSTs offer.
There are also, however, some advantages over the TIC structures that are otherwise used for 1031 exchanges.
Banks are not involved directly with the investors, so that exit strategies may be enhanced.
DSTs may provide an additional option that wouldn’t otherwise be available during the 45-day identification period.
The limitation to 35 investors applicable to TIC structures also doesn’t apply to DST investments.
A 1031 exchange can be an important tool for tax deferral, and DSTs can be another tool in the arsenal of investors who want to take advantage of such exchanges. It’s important, though, to be armed with some background knowledge and the help of skilled professionals.
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