Investing in a Delaware Statutory Trust (DST) has gained popularity among real estate investors, especially those looking to defer capital gains taxes through a passive 1031 exchange investment. However, despite its allure, there are several reasons why one should exercise caution before committing to this type of investment. A quality 1031 advisor should educate investors on the reasons why one should think twice before investing in a DST, not just the potential benefits. The topics below should be carefully considered before investing in a DST.
1. Lack of Control
When you invest in a DST, you effectively relinquish control over the management of the property. The trust’s sponsor makes all decisions regarding leasing, maintenance, and potential sale of the property. For hands-on investors accustomed to making strategic decisions, this can be a significant drawback. The success of a DST investment heavily depends on the competency and integrity of the sponsor. A poorly managed DST can result in subpar performance, mismanagement of funds, or even fraud. Thorough due diligence is essential, but even then, there are no guarantees.
2. Illiquidity
DST investments are inherently illiquid. Once you invest, your capital is typically tied up until the property is sold, which is usually 5-7 years. Unlike stocks or bonds, you cannot easily sell your interest in a DST if you need to access your funds quickly. Some selling groups advertise a “secondary platform” that offers potential liquidity. Selling shares of a DST may be possible, but it is usually a slow process and/or requires a heavy discount from the seller.
3. Fees
DSTs often come with relatively high upfront fees, including acquisition fees, financing fees, and management fees. These fees can significantly eat into returns, making the investment less profitable than it initially appears. Therefore, investors should compare the fees with other investment options net of their tax consequences to determine whether a DST investment makes sense for their situation. Investors may consider Tenants-In-Common (TIC) if the fees are the primary concern or desires to more closely align the sponsor’s incentives with that of the investor.
4. Potential for Low Returns
While DSTs can offer stable income through rental yields, the returns are generally modest compared to other real estate investments. The combination of fees, the restrictive structure of the DST, and the conservative nature of the properties typically held in DSTs can result in lower overall returns. Investors looking for more upside potential may consider an investment entity with a more flexible legal structure such as a TIC.
5. Financing Opportunity Risks
Investors cannot refinance a property within a DST. This can present a significant opportunity cost if interest rates drop, and the investors are not able to take advantage of reducing the debt expense to potentially reap higher returns. Additionally, the lack of ability to refinance may force the sponsor to sell a property at inopportune times.
6. Tax Complexity
While DSTs can offer tax deferral benefits through 1031 exchanges, the tax implications can be complex. Navigating the tax code and ensuring compliance requires careful planning and often the assistance of a tax professional, adding another layer of cost and complexity to the investment. It is important that an investor consult their tax advisor prior to making a decision to invest in DSTs.
Conclusion
While DSTs can be an attractive option for certain conservative investors, particularly those looking for passive income and tax deferral, they come with drawbacks. The lack of control, illiquidity, fees, and potential for low returns are all important factors to consider. Additionally, tax complexity and the lack of ability to refinance further complicates the investment landscape.
For those who prefer more control over their investments, are seeking higher returns, more flexibility or need more liquidity, buying outright or considering alternative real estate investment vehicles may be a better fit. As with any investment, it’s crucial to thoroughly research and understand the potential risks and rewards before committing one’s hard-earned money.
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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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