A DST (Delaware Statutory Trust) permits a flexible approach to both real estate ownership and investment and qualifies as replacement property for a 1031 exchange. Investors acquire a passive fractional interest and receive annual distributions from the rental income along with profits from the eventual sale of the property. The DST therefore represents a valuable tool for agents/brokers by helping them generate more listings from clients that are concerned about exchange deadlines and are tired of the headaches associated with active property management. DSTs present opportunities obtaining replacement properties in a tight market.
By understanding and communicating the benefits of a DST investment, you can minimize your client’s concerns and help guide them through a 1031 exchange. Here are several ways to introduce DST investment strategies to your clients:
Real estate professionals are finding it challenging in today’s market to locate replacement properties for investors. Whether it’s finding the deal, getting it under contract, or getting it financed, it all adds to the seller’s anxiety and affects their desire to pull the trigger and list. A DST investment can eliminate/minimize these issues as either the primary property or as a backup option. The “3-property” rule represents the most common way to identify properties within the 45-day period. It is easy to provide a DST “fallback” option as long as you have room to identify. Adding a DST allows it to act as an “emergency parachute” by providing your client with the safety of a fallback option.
- Property 1 – Realtor’s choice
- Property 2 – DST
- Property 3 – DST
It should be noted that utilizing the “200 percent rule” for identifying properties can provide the client with additional backup options and flexibility in their 1031 exchanges.
Institutional Quality Replacement Properties
Many investors own properties that have some of the following attributes: 1. lower quality, 2. deferred maintenance 3. poorly managed, 4. fully depreciated 5. generating low returns. The majority of DST investments however, are institutional grade properties with long terms leases and higher occupancy rates. The size, value, and quality of these assets also garnish lower interest rates for major banks, lenders, and agencies. In today’s market, we see returns on equity in the 5-6% range on average. When calculating the sheltered tax benefits the returns on average are generally even higher.
Easy Replacement Solution
We know that some clients are never inclined to sell assets because they are concerned about finding replacement property in the limited time available under the Internal Revenue Code. They are also concerned about the hefty tax bill that comes along with selling property. A DST can therefore enable the agent/broker to obtain a listing by providing the client with the comfort they need to move forward with the exchange. Moreover, the DST provides a great option for “leftover” equity in an exchange that would otherwise result in taxable boot (see next benefit).
Additional Equity or Debt Left Over
Many times, a realtor will sell a client’s property but only find a replacement for some of their proceeds. Example: Property sells at $2M, and the new property is only $1.8M. This would require the seller to pay taxes (boot) on $200,000. Typical DST minimums are $100,000, which could result in your investor picking up another one or two properties, having no tax issues and diversifying their real estate portfolio. Your client may also need additional debt that their 1st choice does not entirely cover.
- Property 1 – $1.8M Realtor’s choice
- Property 2 – $100,000 DST
- Property 3 – $100,000 DST
Replacement Debt Issues
One of the major components of executing a 1031 exchange is making sure that all the debt from the client’s relinquished property is replaced. While debt can be replaced by adding more equity, it is usually not ideal for the seller. Lenders can be fickle with their underwriting, loan to value (LTV) ratios, personal guarantees, appraisals, etc. especially in today’s uncertain market. With a DST however, the debt is completely non-recourse to the investor so there is no individual underwriting. The investor gets the benefits of the debt (tax sheltering benefits; debt matching requirements in the 1031 exchange) but not the personal liability because of the trust structure. DST investments can also be structured to accommodate most debt requirements.
Passive Management – Retiring from the Terrible T’s (Toilets, Tenants & Trash)
Is your client tired of real estate management? The DSTs provide institutional quality professional management services. This enables your clients to retire from the toilets, tenants and trash aspects of owning and managing real estate. This again is a passive investment from the standpoint of your client.
Ability to Diversify with Low Minimums
Diversification is almost always an essential aspect of any client’s investment strategy. A DST investment typically has a $100,000 minimum investment for “Accredited Investors” in a 1031 exchange. These low minimums can assist your client in putting together a diversified real estate portfolio that spans several states and real estate sectors. This is very helpful for clients who are concerned about putting “all their eggs in one basket.”
Legacy Planning Simplified
The old adage in the 1031 exchange industry is that you should “swap until you drop”. This enables an investor to turn a “tax deferred” exchange into a “tax free” scenario by utilizing the IRS’ stepped up tax basis when the investor dies and passes the property to his/her heirs. Since the investor can not simply sell the property during his/her lifetime without tax consequences, the agent/broker acquires a potential lifetime client for all future transactions. Moreover, the passive structure of the DST ensures that the heirs have no management responsibilities along with a stepped up tax basis that potentially eliminates all tax liability.
Make sure to recommend that your clients consult their tax advisors on whether or not DSTs are right for their real estate investment goals.