Navigating the array of opportunities available to 1031 investors can be overwhelming. Determining the most suitable investment option requires careful consideration and thorough evaluation. Among these options, the Delaware Statutory Trust (DST) has emerged as a favored choice for many investors who meet specific criteria. This article aims to guide exchange investors by highlighting key questions they should ask before deciding if a DST is the right fit for their investment goals.
1. Am I an Accredited Investor?
DST investments are generally only for accredited investors, as defined by the SEC. An accredited investor is someone who meets certain income or net worth thresholds, such as:
- Having an individual income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000.
- Having a net worth exceeding $1 million, either individually or jointly with a spouse, excluding the value of the primary residence.
- If using an entity with multiple owners, the entity must have total assets of over $5M, or each of the owners must meet the personal accreditation requirements.
Before investing, it’s important for investors to talk to their tax advisor to see if they qualify.
2. Am I Comfortable Giving Up Control?
One of the primary potential benefits of investing in a DST is the complete relief from day-to-day management responsibilities. In a DST, professional property managers handle all aspects of property management. This includes dealing with tenants, maintaining the property, and handling any repairs or improvements needed. For investors, this means no more late-night calls about broken appliances or the need to personally oversee property upkeep. However, this also means the investor gives up control completely. The sponsor is responsible for all the decision-making regarding the property on behalf of the investors.
3. How Much Do I Want to Diversify?
DSTs allow investors to diversify their real estate portfolio by investing in multiple high-quality properties across various asset classes (e.g., commercial, multifamily, retail) and geographic locations. This diversification can help mitigate risk, which is attractive to investors looking to spread their investment across different markets and property types. However, it can never remove all the risk. Additionally, breaking up one’s exchange into small chunks degrades their ability to purchase their own property when the DST sells. For example, by breaking up $500,000 into five $100,000 investments may provide diversification, but it is unlikely the DSTs will sell together. Therefore, the investor may have a hard time finding a property cheap enough to buy on her own when one of the DSTs sells for a little more than $100,000. Additionally, diversifying into various properties across multiple states may result in additional tax filing and could generate additional administrative burden expenses.
4. Do I Need a Quick Closing?
Investors facing a tight timeline for completing a 1031 exchange may benefit from DSTs, which are pre-packaged and ready for immediate investment. This can be particularly advantageous for those who have sold their property and need to identify a replacement property within the 45-day identification period. However, DSTs can sell out their equity with short notice, surprising the exchanger when the DST is no longer available as they expected. Additionally, holding the property for investors for a long period can often be expensive because of expensive bridge loans with high interest rates, which is typically paid off by investor equity.
5. How Significant Is My Tax Consequence?
Investors who have significant capital gains from the sale of a property and want to defer paying taxes on those gains can use a 1031 exchange into a DST. This allows them to reinvest the proceeds into another income-producing property without immediate tax consequences. However, investors may have losses elsewhere in their portfolio, or may not have a tax consequence large enough to justify the cost of a DST. Important that investors speak to the tax advisors prior to making a decision whether to 1031 or to pay their taxes.
6. Am I Ok Holding Long Term?
DSTs typically hold stabilized properties with little moving parts or opportunities for improvement. Investors who are looking for steady, long-term holds without much value-added opportunity may be a good fit. Most DST properties rely on the local submarket for appreciation. Additionally, the loans utilized to purchase commercial real estate in DSTs usually come with heavy prepayment, defeasance, and yield maintenance fees in the initial years. Therefore, DSTs should be considered illiquid and long-term investments, typically 5-7 years. However, if the real estate market remains relatively flat, this could be an even longer hold.
Conclusion
Typically, a good candidate for a 1031 exchange into a Delaware Statutory Trust is an accredited investor seeking passive income, diversification, and tax deferral benefits, with a preference for long-term investments and a need for a quick and efficient 1031 exchange solution. These investors are typically looking to reduce their active management responsibilities and manage their investment risk more effectively.
However, DSTs are not right for everyone. Investors must be willing to pay a premium for the pre-packaged 1031 solution. They must be willing to completely give up control. Investors must be willing to hold long-term with expectation for exceedingly modest returns.
For those looking for a little more upside potential, potentially less fees, and more flexibility for the sponsor to drive up potential returns, a Tenets-In-Common structure may be more appropriate. Either way, there is no perfect deal, and 1031 exchangers should conduct their research ahead of time so they are not rushing to develop their investment criteria while in the time crunch of their 1031 deadlines.
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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. Section 1031 rules that must be carefully followed to qualify for a 1031 exchange. We strongly encourage you to seek guidance from both a qualified intermediary (QI) and a tax professional to navigate his process and ensure compliance with relevant regulations. Please note that RealtyMogul does not provide tax advice.
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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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