Usually the most difficult issue clients face in a §1031 exchange is finding suitable replacement property within the tight 45-day identification period. Particularly in a seller’s market, we hear woes of cap rate compression from nearly every investor. Even when they find a property, they still need to negotiate an acceptable price and complete their due diligence. That is a big to-do list in a short time period, and if the property they identify doesn’t work out, they are out of luck and have no choice but to pay their taxes.

One possible solution for taxpayers in such a bind 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 viewed as the acquisition of a fractional interest in the underlying property, similar to acquiring a tenant-in-common interest with other investors.

However, because a DST investment is viewed as a Regulation D offering by the SEC, a taxpayer must meet the SEC’s definition of an “accredited investor.” These investments are therefore limited to higher net worth individuals.

Advantages of a DST

Assuming the taxpayer qualifies, a DST offers several advantages over other types of real estate investments:

  • Availability. At any given moment, various sponsors offer many DSTs in a variety of marketplaces and in almost every real estate sector. Taxpayers facing the expiration of their 45-day identification period can often identify one or more DSTs even at the last minute, and closing on a DST interest can happen quickly, most often well within the 180-day exchange period.
  • Diversification. Because DSTs are available in many regions and market segments, taxpayers can invest outside of their local region and in a different market segment. For example, a taxpayer might exchange a six-family rental house in Brooklyn for a DST interest in an office park in Silicon Valley and another in a hotel in Orlando.
  • Freedom from management. Properties held by a DST are managed by the trustee or an affiliate, so taxpayers can escape the management headaches of the “three Ts”: tenants, trash and toilets.
  • 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 on their own.
  • Investment matching. DSTs allow the taxpayer to match equity and debt requirements more precisely to fully defer any gain. If they sold their relinquished property for $1 million and paid off a $500,000 mortgage, they could acquire a DST investment with similar equity and debt. Because the trust is the borrower, the taxpayer does not need a separate mortgage, and the financing is non-recourse to the taxpayer.

What to keep in mind

DST investments are still real property, so they are subject to the same market risks as other real estate investments. Like other real estate, DSTs are also not liquid. Typically, the taxpayer should plan to be invested for five to seven years, and possibly as long as ten, which are the typical timeframes in which the underlying real estate would be sold, allowing the taxpayer to either recognize their gain or acquire other replacement property through a §1031 exchange.

Acquisition and management costs for a DST may also be higher than a typical real estate investment, so it is important to ensure the anticipated returns justify the expenses. Finally, because there are many DST sponsors and properties available, due diligence is still a necessity before selecting any investment.