I.R.C. Section 1031Tax Deferred-Exchanges allows the taxpayer to sell (relinquish) its investment real estate and defer paying the capital gains taxes (and other taxes) on their profits when they reinvest the proceeds into other investment Replacement Property(ies).
One of the possible Replacement Properties possibilities being used today is the Delaware Statutory Trust (DST). We will now cover the Pros and Cons of DST’s.
The Pros
DST’S AS REPLACEMENT PROPERTY
An interesting factoid, DST’s are categorized as a security by the Securities and Exchange (SEC) Commission BUT are treated for tax law purposes, as an ownership of real estate. Because IRS has allowed the DST vehicle to be treated as a piece of real estate, the taxpayer can use a DST as either a Relinquished or Replacement Property for Section 1031 purposes. The IRS Revenue Rulings have served as an incentive for the Sponsors of the DST programs to underwrite and offer through securities broker/dealers, institutional quality real estate investments that can meet IRS’s stringent Section 1031 restrictions, which help real estate investors meet their goals of tax deferral, passive ownership, preservation of principal and a predictable cash flow.
HIGH-QUALITY GRADE ASSETS
DST’s are investment properties that allow investors to own a fractional interest in large, high-quality properties that the taxpayer would normally not be able to own a piece of.
THE 45 DAY AND 180 TIME-LINE RESTRICTIONS
Timing is everything when it comes to Section 1031 exchanges. The taxpayer must identify possible Replacement Properties within 45 days of the sale of the Relinquished Property and must complete their 1031 transaction by acquiring their Replacement Property within 180 days of the sale of the Relinquished Property. Should you fail to identify within the 45 days or fail to close on the identified Replacement Property within the 180 days, your Section 1031 Tax-Deferred Exchange will fail. So then why is this in the Pro Section? Because DST’s can be identified and closed within a very short time period. One of their sales pitches is: “Identify our DST as one of your Replacement Properties and we can close very quickly; so if you had decided on another property and it does not close, you can close with us quickly”.
SIZE OF FUNDS NEEDED
One of the major obstacles in a Section 1031 exchange is that the taxpayer is looking for a property that closely matches the dollar amount of the Relinquished Property they just sold. Maybe they can find something a little more expensive or something a little bit less. With a DST product, you usually can invest the exact amount needed to satisfy your exchange dollar amount requirements.
DIVERSIFY, DIVERSIFY, DIVERSIFY, DIVERSITY
the taxpayer can DIVERSIFY into a number of different DST investments. So, the taxpayer could purchase interests in a DST that has a property in Oklahoma and purchase another DST property in Michigan. For that matter, the taxpayer could purchase a DST product that has as its asset an office building, and then the taxpayer can use its remaining funds to purchase another DST product that has as its asset a shopping center. As you can see one of the strong points of DST’s is that the taxpayer can diversify their investments.
NON-RECOURSE DEBT
If there is financing on the DST property, the loan is non-recourse, which means that the taxpayer is not personally liable for the loan. The only collateral for the loan is the real estate.
The Cons
Some of the key drawbacks to DST’s are:
LACK OF PERSONAL CONTROL
The DST Sponsor makes all of the decisions on behalf of all of the taxpayers. The taxpayer really has little input into what goes on with the property.
RAISING CAPITAL OR REFINANCING THE DST
No additional contributions or additional investors are allowed after the DST offering is closed. This can raise a number of problems when the investment property needs to have a roof repaired or replaced, or the resurfacing of a parking lot or painting of a building is required. The property’s cash flow can be reduced should there be a reduction in occupancy or rents received. The above issues can happen at any time and can be exacerbated by Disasters, such as the COVID-19 pandemic or storms such as hurricanes or tornadoes, or for that matter, the floods that occurred in the Midwest or the fires on the west coast of the United States. These types of issues will erode the investment’s cash flow.
DST’S ARE ILLIQUID
Typically, DST’s have a five to ten-year, long-term hold, before they are re-sold by the Sponsor. While the DST programs have helped real estate investors address the traditional challenges of a Section 1031 exchange, DST investors are discovering that having a minority share in an investment, without any prospect of an exit, is a concern. One of my friends described the DST exit strategy as follows: “Unless there are other investors that could take their place or the project could be sold in its entirety, there is no way to get the investment monies out.” Let me conclude this missive by saying that there is a solution to the illiquidity issue of DST’s. I have been in contact with a privately held firm that specializes in illiquid asset investing. They purchase DST’s, albeit at a discounted price, but are able to fund the purchase of the DST, in most cases, in less than a week. So the Good News is that there is some type of help out there when trying to exit a DST investment.
Read Part 1 of this missive with this link.
LIBERTY 1031, LLC always recommends that the taxpayer should consult their tax and/or legal counsel on all matters dealing with the Internal Revenue Service.
I personally look forward to working with you on your next Section 1031 exchange. To answer any of your questions or to open a Section 1031 transaction, please contact Stephen A. Wayner, Esq. CES at our toll-free telephone number: 866-903-1031 or at swayner@liberty1031.com.
