There are many benefits of owning commercial real estate. The asset class provides income and appreciation potential, competitive risk-adjusted returns, tax-efficient cash flow and the ability to use leverage. The main drawback for investors is that private, active ownership of real estate is management intensive.
At some point in their investment journey, these active owners will progress out of the accumulation and growth phase. They may be approaching retirement and are seeking to reap the benefits of their investments without all the work, focusing more on capital preservation and income. Converting from active to passive ownership is possible by exchanging invested property into a 1031 exchange and using a DST, or Delaware Statutory Trust.
The Investor Journey
What is a DST, and How Does it Work?
A 1031 exchange allows investors to defer capital gains taxes on the sale of a real estate investment property. They do this by “exchanging up” into other—usually higher-value—properties. (Read more about how 1031 exchanges can help investors defer taxes and simplify estate planning, among other benefits.) In completing a 1031 exchange, an owner exchanges the sale proceeds from their relinquished property into “like-kind” property. This simply means, among other criteria, that both assets must be considered real property held for productive use in a business or for investment.
Delaware Statutory Trust, or DST, investments allow owners of real estate investments to pool their capital. Then, they exchange it for institutional assets with professional management. For example, an investor owns a property worth $500,000. By employing a 1031 exchange, they can convert that ownership to another property worth $500,000. But by employing a DST, they can roll their investment into a property or properties worth much more. Even better, the DST provides a passive ownership structure.
A Delaware Statutory Trust qualifies as “like-kind” for the purposes of a 1031 exchange. According to IRS Revenue Ruling 2004-86, which went into effect in 2004, owners of real property can exchange their assets, called the relinquished property, for part ownership in real property, called the replacement property.
Key Benefits of DSTs for Investors
Some key benefits to investors include:
Tax deferral. DST investors receive the same tax benefits as if they had completed their own 1031 exchange. That means they can fully defer all taxes due on the sale of the relinquished property. Federal capital gains taxes, state income taxes and depreciation recapture are all deferred. As well, the basis from the original property is rolled over.
Passive ownership. Most real estate investors utilize a DST to eliminate active management—the three Ts of toilets, tenants and trash. The DST transfers all management responsibility to the sponsor and gives the client all the benefits of ownership.
Ability to exchange “up.” Investors acquire a fractional interest in a trust that manages a larger or institutional-quality asset. It’s not simply a “like-kind” exchange of a similar property.
Professional management. The replacement property is managed through the DST. So, investors no longer need to directly manage a property and can spend more time doing what they love.
Passive income and simplified estate planning. Landlords exchange day-to-day property management for the benefits of a passive, monthly income stream. And beneficiaries inherit interest in a security, rather than a property, through an estate or trust. If they decide to liquidate the real estate, there are minimal tax implications.
Matching debt and equity. Investors must replace the full value of relinquished real estate. It can be difficult to find assets that directly match the proceeds and to get financing on the new property. A DST is typically structured with non-recourse debt. So, the investor assumes the leverage and can invest as much equity as they need for the exchange.
Before You Invest: Limitations to DSTs
Owning tangible property is more complex than owning a share of stock. DST investments come with certain risks and limitations, and investors should understand these key points before proceeding.
Lack of liquidity. Owning real estate means owning an illiquid asset. A DST interest is highly illiquid and can’t be converted into cash. For this and other reasons, investors in DST investments must be accredited investors. Typically, this is an individual investor with $1 million or more of net worth.
Lack of management control. Management is truly passive. DST sponsors professionally manage the asset. That means investors do not have direct decision-making authority.
The Seven Deadly Sins of DST Investing
DSTs must operate according to seven key criteria in IRS guidelines. These have become known as the “seven deadly sins” among those who employ this strategy to defer capital gains. Investors receive an ownership percentage but relinquish voting and operational management privileges when they invest in a DST. The regulations, described below, were put in place to ensure the DST meets the IRS’ “like-kind” requirements:
- No additional equity contributions: Investors make a single equity contribution upon formation of the DST. Since capital calls are not allowed, all future expenditures must be capitalized upon formation.
- No refinancing of debt: Mortgages placed on the property cannot be refinanced.
- No reinvesting of sale proceeds: Any proceeds earned by a DST must be distributed to investors. It can’t be reinvested by the trustee.
- Limits on capital expenditures: Normal repair and maintenance of the asset, among other things, are allowed. But unnecessary upgrades or other activities that could put investor money at risk are not.
- Limits on cash investments: DST sponsors can only invest cash in short-term debt or another vehicle—nothing speculative—until it’s time to distribute to investors.
- Cash distributions: The DST is required to distribute earnings and proceeds to investors within the agreed distribution date.
- No new leases or renegotiations: Most DSTs use a master lease structure. This means the master tenant negotiates existing leases and enters new ones. This keeps the trustee from renegotiating a lease that could change the terms of the DST investment.
Why Invest in a DST Through Origin Exchange?
A DST can invest in any asset class of commercial real estate—multifamily, office, industrial or retail. Origin Investments focuses exclusively on multifamily investing because we believe its market fundamentals are strong. And we have proven expertise as risk managers in diverse economic conditions. By investing in a DST through Origin Exchange, investors receive the following benefits:
Origin deal sourcing. The DST will own real estate consistent with the IncomePlus Fund’s stringent investment criteria. This Fund is designed to deliver a tax-friendly blend of monthly income and long-term capital appreciation to accredited investors.
Institutional-quality properties. Investors have access to the same quality deals that Origin Investments includes in its Funds. These are multifamily properties in the path of growth, geographically diversified in Origin markets across the U.S.
Geographic diversification. DSTs will be in markets that Origin’s deal-sourcing team believes have the highest potential for growth (see below). Our market analysis includes the use of Multilytics℠, our proprietary machine-learning model that uses billions of data points to zero in on clusters of high-potential submarkets. A DST gives the investor the opportunity to diversify into one of these growing markets.
Origin’s Investment Markets
Low fees: Syndicated DSTs through brokers can have upfront fee structures as high as 14%. We charge an acquisition fee and a fee for organizational and offering expenses. And we don’t pay any brokerage sales commissions.
Matching debt and equity. It can be difficult for investors undertaking a 1031 exchange on their own to find assets that replace the full value of the relinquished real estate. It may also be difficult to get appropriate financing on the new property. A DST is typically structured with non-recourse debt. So, the investor can assume the leverage to replace leverage from the relinquished asset.
Surety of closing. The IRS allows 180 days from the time a relinquished asset is sold to the time the investor must close on the replacement property. By the time an investor begins due diligence on the DST, Origin has done due diligence, negotiated a purchase price, financed and closed on the asset. The equity in the property is available until fully subscribed to investors. And they will not have to worry about the DST falling through as one of their identified assets.
Less potential downtime on an investment. Investors can subscribe to the DST before closing on their relinquished asset. After closing and setting up a qualified intermediary to receive the payout, they can initiate the wire from the intermediary to the DST. And they can be invested in the DST one or two days later. This greatly minimizes the amount of time that investors do not receive income on their principal.
Ownership restructuring. A 1031 exchange requires that the relinquished and replacement properties be titled in the same name. If a limited liability corporation with three members owns a property and wishes to complete an exchange, the LLC must do the exchange, not the individual members.
Want to Learn More?
Every investor has a unique situation and circumstances. It’s important to understand the strengths and risks of a DST structure. Are you considering selling investment real estate? It’s important to work with a qualified team familiar with real estate transactions. Learn more about whether Origin Exchange is an investment solution for you and how 1031 exchanges and 721 exchanges work.
