Are you an investment property owner considering selling, but aren’t sure if you want to invest in another property? Maybe you enjoy the benefits of ownership (passive income, tax benefits), but no longer want the responsibilities of caring for a physical property (maintenance, dealing with tenants, etc).

Enter the DST 1031 exchange. Along with a traditional 1031 exchange, it’s a popular tool among property investors to defer capital gains tax on the sale of an investment property. But it has some added benefits for investors who want an even more passive way to earn income on their investment. 

Let’s take a look at how DST 1031 exchanges work, how they differ from traditional 1031 exchanges, and how to determine if they’re the right investment option for you.

What Is a 1031 Exchange? Definition and Basic Structure

The 1031 exchange (U.S. Internal Revenue Code Section 1031), allows you to defer capital gains tax on the sale of an investment property as long as you reinvest the proceeds of that sale into “like-kind” property. Like-kind property can include any real estate held for investment or commercial purposes, including commercial buildings, agricultural land, multi-family housing, retail spaces, industrial warehouses, and more.

There are a few important rules that every 1031 exchange must follow:

• The replacement property must be identified within 45 days
• The purchase of the replacement property must close within 180 days
• Both properties must be held for productive use in trade/business or investment
• The purchase value of the replacement property must be equal to or greater than the value of the property sold
• All cash proceeds must be used. Debt can be replaced with new debt or additional cash. 
• The exchange must be facilitated by a Qualified Intermediary, who holds proceeds from the sale of the relinquished property in a trust or escrow account and transfers the relinquished property to the buyer and the replacement property to the investor.

Learn more about 1031 exchanges in this blog.

What Is a Delaware Statutory Trust (DST)?

A Delaware Statutory Trust (DST) is a legal entity that pools funds from multiple investors to acquire investment real estate. When investors purchase a fractional interest in a DST, that purchase qualifies as direct property ownership for IRS purposes. It can also qualify as a like-kind replacement property for an investor’s 1031 exchange.

Benefits of a DST Investment:

Access to high-quality properties. Properties owned by DSTs are typically larger, high-quality real estate properties. By pooling their resources, investors in a DST are able to maintain partial ownership of properties that may be otherwise inaccessible to them. 

Hands-off management: As DST properties are professionally managed by a third party—typically a trustee or sponsor—investors enjoy all the benefits of ownership without the responsibilities of property maintenance or tenant relations.

Diversification: Investors can purchase an interest in several different DSTs, allowing them to invest in multiple markets and property types. This diversification helps reduce investment risk as compared to single-property ownership.

Lower minimum investment: A DST can allow for a lower minimum investment than a typical investment property purchase.

Access to non-recourse financing: When you invest in a DST, the DST is typically the sole borrower, so you can benefit from non-recourse debt that limits your liability.

Potential Risks of DSTs

Less control: With a DST, you relinquish control over management decisions and property operations to the sponsor. The sponsor’s track record and experience can be one of the most important aspects of your decision to invest in a DST.

Illiquidity: It may be more difficult to sell your fractional interest in a DST than it would be to sell a traditional property. Carefully review the offering documents before investing to ensure you understand the risks of this illiquidity.

Fees and expenses: Your DST investment may be subject to management fees, disposition fees, and other costs. Any up-front fees (such as commissions, financing fees, and broker-dealer allowances) are capitalized into the DST transaction.

How a DST 1031 Exchange Works

A DST 1031 exchange works much the same way as a typical 1031 exchange, except that the replacement property is an interest in a DST, rather than a typical investment property purchase.

Step 1: Consult with real estate and tax professionals to determine if the property you are considering selling will qualify for a 1031 exchange.

Step 2: Sell the investment property.

Step 3: Engage a Qualified Intermediary to take receipt of the sale proceeds.

Step 4: Identify an appropriate DST interest* within 45 days of the sale of the relinquished property.

Step 5: Close on the DST interest within 180 days. At closing, the Qualified Intermediary transfers the funds for purchase into the DST.

Step 5: Once the exchange is complete, you will have a beneficial interest in the DST. You can then enjoy passive income and a deferral of your capital gains taxes.

*Note that if the DST you invest in is in a different state from your initial investment property, you may incur tax consequences related to nonresident property ownership. Consult with a tax professional to learn more and for help navigating this issue.

Work With CERRON Commercial Properties for Your Next Real Estate Investment Purchase

We hope this blog helps you more fully understand the benefits of a DST, how it differs from a traditional 1031 exchange, and how you may be able to incorporate these tax-saving tools into your investment plans. 

However you choose to invest, the team at CERRON Commercial Properties would love to be a part of your next commercial property purchase. We are well-versed in the options available for real estate investors—including the different types of 1031 exchange.

Contact us today to learn how we can help with your next commercial property investment.

Looking for an advisor to help you complete your 1031 or DST 1031 exchange? We consulted Joshua McKinley at Cannon River Capital Advisors, LLC for this blog, and we highly recommend their services!

Disclaimer: This information is for general knowledge purposes only, and should not be considered real estate or financial advice. It is advisable to consult with your accountant or tax advisor to review your particular transaction and determine if a DST 1031 exchange is right for you.