Frequently Asked Questions
DST 1031 Exchanges are powerful investment vehicles that offer access to institutional quality real estate and institutional management. Investors become limited partners in the form of passive ownership and do not have to actively manage the property. Investors can also gain investment diversification in the form of their DST portfolio being located across different geographic regions.
Institutional quality real estate generally refers to property of sufficient size and stature to gain attention from established national and international investors such as REITs, investment banks, hedge funds, and foundations.
Institutional quality real estate access lends exposure to better deals usually offered to institutional investors, opposed to retail investors, which can then offer better negotiating power, better contractual opportunities, and lower fees.
Since investors take on a limited partnership, the assets under management are under the control of the general partner. DST 1031 Exchanges hold a longer investment horizon since these vehicles offer lower liquidity options regarding investors’ exit strategies and no public market exists for DST interest. Higher fees are generally associated with this investment option since the general partner is responsible for every aspect of the real estate deal including, but not limited to, brokerage services and property management.
First, a sponsor will create a DST to hold the real estate assets. The sponsor is then responsible for management, leasing, upkeep, taxes, insurance, investor reporting, and mortgage financing for the property under the DST. The sponsor offers the beneficial interest issuance to individual investors. The interest is securitized through a broker-dealer. The broker-dealer conducts due diligence, negotiates selling agreements, and monitors FINRA compliance. The investors can 1031 Exchange proceeds from a sold investment property into the DST by working with registered representatives to create optimal real estate investment portfolios for the individual investors and their financial advisors’ needs.
A sponsor is a real estate company that holds expertise and experience in property management and real estate ownership. Sponsors locate deals and negotiate terms of the purchase and sale agreement all whilst conducting due diligence on potential investment properties at hand. Responsibilities for the transaction, on-going operations, and mortgage financing are all taken by the sponsor as well.
Yes, 1031 Exchange lets investors sell an investment property and reinvest their capital into another like-kind investment property deferring capital gains taxes and depreciation recapture taxes from the sale. DSTs are trusts that use 1031 Exchange proceeds to purchase and manage the real estate properties owned by the trust.
Properties are considered like-kind properties if they are the same in nature or character and can differ in grade and/or quality.
DSTs might be an optimal solution for an investor if they are looking to be a passive investor and mitigate managing their current investment property. If they are looking to gain access into higher quality real estate or institutional properties, DSTs could prove beneficial. A DST can also serve as backup plan while identifying another investment property if their potential primary property deal falls through during the 45-day identification window. DSTs can serve useful if there is a gap in the sale of the investment property when lining up a transferrable property meaning if there is an excess in capital gains from the previous sale versus the newly identified investment property, the difference in sale can be transferred into a DST.
DST 1031 Exchanges are limited to accredited investors. Qualifications vary by local market regulators or other competent authorities. An accredited investor is an institution or person that can partake in financial transactions not available to the rest of the public. Investors qualify by passing income, net worth, asset size, and professional experience requirements.
DSTs are considered illiquid investments meaning investors should prepare to have their money locked in the trust for an investment horizon of 5-10 years. When it comes to a transfer of interest regarding an investor’s share of the trust, locating demand is difficult since no two trusts are the same and every investor’s needs are different. Private exchanges of interest can occur, but they are rarer than the investors’ holding their interest for the life of the trust. There is also no public secondary market for these securities.
Exit strategies range dependent upon the investor’s needs. The most common exit involves investors holding their interests for the full cycle (explained below). Another option would be for individual investors to try and exit the trust early. Generally, if an investor wants to sell their interest in the DST, the sponsor will notify all other DST investors of the potential exit. There is no guarantee that the investor will be able to exit because another investor will need to be located to purchase the interest and a price needs to be agreed upon for the interest. Hence, investors should only consider DSTs if they are able to hold the investment for the full life of the trust. Another exit involves real estate companies, REITs, or other investment institutions purchasing investors’ interests in a DST, offering individual investors an exit.
A full cycle is the term used to describe the length of time from when the DST is established until the DST sponsor sells the assets according to the DST’s business plan.
A DST will be structured by the sponsor. The trust will own 100% of the fee interest in the real estate resulting in the trust whilst being the only borrower and holder the loan. The sponsor then approaches a broker-dealer to find individual investors to purchase interest in the trust, giving individual investors access to invest in institutional-grade real estate. The investors in a DST own a pro rata interest and hold the rights to the distributions from the trust’s operations. The trust itself holds the deed to the property and makes decisions regarding the operations and sale of the property.
Although Delaware Statutory Trusts have been around since the late 1980’s, it was not until 2004 where investors were able to 1031 Exchange property into a DST and defer capital gains under a like-kind transfer of real estate. The IRS Revenue Rule 2004-86 explains how DSTs are classified for federal tax purposes and whether a taxpayer may acquire an interest in the DST without recognition of gains/losses.
Tenant-in-common (TIC) investment structures were developed in the early 1990’s and grew more popular after the IRS in 2002 considered TIC investment properties as qualified replacement properties for 1031 Exchange transactions. When limitations of TIC structures started arising, the fractional ownership structure known as a DST popularized. TIC investment property offerings limit no more than 35 co-investors sharing the interest, constraining the size of transactions that can be brought to market by sponsors. The TIC structure also forced each individual investor to form their own LLC while simultaneously arranging for lender financing for each investor which could result in burdensome underwriting and closing processes. TIC investors must vote unanimously on all major investment decisions, potentially leading to impasses of decision making. The introduction of the DST led to a clearer and more risk-averse approach in transacting a 1031 Exchange. The DST does not require each individual member to form their own LLC since the trust is established under sponsor, who secures all the financing. In DSTs, investors are not given voting rights, mitigating any investment decision gridlock that could have been caused by a TIC structure. DSTs also hold a limit of 499 individual investors who can purchase interest in the trust, increasing the quality and lifting capital contribution limitations previously seen by the TIC.
DSTs cannot be advertised to public because you must be an accredited investor to contribute. DST 1031 Exchanges are a newer security, relatively speaking, gaining popularity in the last decade. These instruments involve tax complexity, illiquidity, and passive ownership which might not suit all individual investors.
Within the context of a 1031 Exchange, boot is tax liability generated from the sale of an investment property. The liability is created when the full proceeds from the sale are not transferred through the 1031 Exchange. Liabilities occur when the totality of the sale’s proceeds are not fully utilized in the purchase of the new investment property. The same combination of debt and equity used to purchase the previous property, plus any capital gains, must be used in the purchase of the new investment property.
For example, if I sold an investment property for $300,000 and originally used $100,000 of debt to finance the original purchase and $100,000 of my own equity, the property has a capital gain of $100,000. This means, for my 1031 Exchange, I would have to use $200,000 of cash and $100,000 of debt to purchase the new investment property avoid generating any boot. If I only used $175,000 of cash and $100,000 of debt, I would be subject to a capital gains tax on the $25,000 I did not utilize (this is called cash boot). Vice versa, if I used $200,000 of cash and only $75,000 of debt, I would be subject to a capital gains tax on the $25,000 I did not utilize (this is called mortgage or debt boot).
Taking the example above one step further, if the investor were to sell the $300,000 investment property and 1031 Exchange the proceeds into a new investment where they used $175,000 of cash and $125,000 of debt, increasing the loan value by $25,000, they would still generate cash boot. Debt cannot be used to replace equity in a 1031 Exchange. Although, if the investor were to complete the same transaction with $225,000 of cash and $75,000 of debt, they would not generate a mortgage or cash boot. Cash can be used to replace equity in a 1031 Exchange if the total proceeds of the sale are being utilized.
Typically, DST 1031 Exchange minimum investments range from $50,000 to $100,000. Every scenario is different, causing variance in the minimum investments required.
There is no maximum investment for a DST 1031 Exchange. The interest offered to investors depends on the size of the DST. Theoretically, a ceiling exists equal to the amount of equity available to investors, although it is a rarity to become subject to this.
Not an offer to buy, nor a solicitation to sell securities. All investing involves risk. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing. Any information provided on this site has been prepared from sources believed to be reliable, but is not guaranteed by Tangible Wealth Solutions or Colorado Financial Corporation and is not a complete summary or statement of all available data necessary for making an investment decision. Any information provided is for informational purposes only and does not constitute a recommendation.
Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.
1031 Risk Disclosure:
- There is no guarantee that any strategy will be successful or achieve investment objectives;
- Potential for property value loss – All real estate investments have the potential to lose value during the life of the investments;
- Change of tax status – The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;
- Potential for foreclosure – All financed real estate investments have potential for foreclosure;
Liquidity – Because 1031 exchanges are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.
- Reduction or Elimination of Monthly Cash Flow Distributions – Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;
- Impact of fees/expenses – Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits