Introduction
Delaware Statutory Trusts (DSTs) have become a popular investment vehicle for real estate investors, particularly those involved in 1031 exchanges. One of the most compelling features of DSTs is their ability to easily access non-recourse debt that satisfies 1031 exchange requirements and provides numerous other potential benefits. This article explores the various advantages of leveraging debt within a DST, highlighting how it may potentially enhance investment returns, offer significant potential tax efficiencies, and provide a turn-key solution for investors looking to maximize their real estate portfolio while minimizing active management responsibilities. However, it is crucial to understand the risks associated with debt, including the potential for amplified losses and cash flow volatility. The purpose of this article is to provide general education to investors on the potential debt opportunities that DSTs offer and help them develop a strategy that best fits their own criteria and risk tolerance.
Turn-Key Built-In Debt
In a DST, investors are not required to sign for the loan on the property. Investors do not need to apply for the loan, and it typically does not show up on a credit report. Yet they realize the potential benefits and risk that are associated with a loan and can use it to satisfy the 1031 requirement per the IRS. This turn-key nature has been a significant reason many exchangers have flocked to DSTs for their 1031 solution. As interest rates increase and lenders become more conservative, the certainty of being able to close on a 1031 exchange has increased the demand for DSTs.
Non-Recourse Financing
Not only are exchangers not required to sign for the loan on the property, are not underwritten by the lender before investing, and do not have to apply for the loan. Additionally, the investor cannot be held liable for paying back the loan beyond the principal invested. The revenue from the property pays the debt expense, and the proceeds from the sale of the property pays off the mortgage. Therefore, if the property value drops below the loan obligation, lenders cannot go after the investors to recover their losses.
Increased Upside Potential
Leverage can increase the potential profits for a DST investor. For example, if an exchanger invests in a DST with a 50% loan-to-value (LTV), it will purchase an additional dollar of property for each dollar invested. A $100,000 investment would buy $200,000 of property. If the property value appreciates 1%, the exchanger’s investment value goes up 2%. Buying more property can also potentially increase cash flow and the cash-on-cash return. If the loan amortizes, the investor can build up equity in the property as if they owned it outright. However, investors should remember that debt can both amplify the upside and the downside, potentially leading to accelerated losses and cash flow volatility.
Potential Additional Tax Benefits
Many 1031 exchangers have fully depreciated their basis, and by taking on additional debt, they can acquire more property and expand their basis. This expanded basis can then be depreciated, providing further tax benefits that can shelter some or all revenue from income tax. Additionally, some DSTs may generate enough tax losses to shelter income from other DSTs or other passive income. Furthermore, interest payments on the debt are often deductible, potentially reducing the taxable income generated by the investment. These tax advantages make debt in a DST an attractive strategy for investors seeking to optimize returns while minimizing their tax burden, especially in high-income tax states like California.
Limit Foreclosure Risk Through Diversification
DSTs offer varying levels of LTV, typically ranging from 0% to 90%. Investors can often mitigate their portfolio’s exposure to foreclosure risk by consolidating the debt required to complete their 1031 exchange into only one or two properties. Once their debt obligation is satisfied, they can invest the remainder of their equity into debt-free DSTs. For example, if an investor sells a property for $1,000,000 and has a $100,000 loan, they can invest $100,000 into a DST with 50% LTV, buying $200,000 of property. The remaining $800,000 of equity can be invested into debt-free DSTs, limiting their portfolio’s exposure to lender foreclosure risk while satisfying their requirement to purchase property of equal or greater value. Since DSTs accept investment increments down to the dollar, exchangers can match their debt requirements to the exact amount.
Additional Thoughts
There is a premium to invest in DSTs. In a bull market, the fees may not materially impact the investment. In a flat market, the fees may have a detrimental impact on the total return. These fees typically include acquisition fees, management fees, and administrative costs, which are incurred regardless of the property’s performance. Without leverage to potentially amplify returns, the income generated by the property must be sufficient to cover these fees and still provide a desirable return to investors. This can be particularly challenging in markets with lower rental yields or when unexpected expenses arise, reducing the net income available for distribution. Therefore, debt may be an important consideration when evaluating the sponsor’s ability to exit the DST and provide the investors a profit on the back end.
Conclusion
The built-in financing has positioned the DST as a popular 1031 solution for landlords looking to retire from active management. The certainty of closure, possibility for amplified returns, and potential tax benefits have added to its appeal. However, debt also comes with risk, including volatility in cash flow and potential loss of capital invested. Investors should consult their advisors and CPA to determine how much debt, if any, is appropriate for their specific situation. Exchangers should also work closely with their RealtyMogul 1031 expert when building their custom 1031 portfolio to help assess the potential risks of debt when applied to various entities, asset types, and asset classes.
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Disclosure
1031 Exchange Risk
Internal Revenue Code Section 1031 (“Section 1031”) contains complex tax concepts, and certain tax consequences may vary depending on the individual circumstances of each investor. RM Securities and its affiliates make no representation or warranty of any kind with respect to the tax consequences of your investment or that the IRS will not challenge any such treatment. You should consult with and rely on your own tax advisor about the tax aspects with respect to your particular circumstances.Please note that RealtyMogul does not provide tax advice.
This article is for informational purposes only, and is not a recommendation or offer to buy or sell securities. Information herein may include forward looking statements and is for informational purposes only. Forward-looking statements, hypothetical information, or calculations, financial estimates and targeted returns are inherently uncertain. Past performance is never indicative of future performance. None of the opinions expressed are the opinions of RealtyMogul. Advice from a securities professional is strongly advised, and we recommend that you consult with a financial advisor, attorney, accountant, and any other professional that can help you to understand and assess the risks and tax consequences associated with any real estate investment. All real estate investments are speculative and involve substantial risk and there can be no assurance that any investor will not suffer significant losses. A loss of part or all of the principal value of a real estate investment may occur. All prospective investors should not invest unless such prospective investor can readily bear the consequences of such loss.
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