In our last post, we discussed the opportunities and challenges unique to 1031 exchanges.
We learned that while the 1031 exchange is a powerful planning tool, it’s limited by IRS rules. Specifically, the requirements around the identification and acquisition of replacement properties can be cumbersome for some investors.
As a result, selling owners who exchange into a direct ownership situation have some pros and cons to consider before the sale:
Today we’ll talk about one 1031 alternative for owners who want to defer taxable gains, but don’t want to deal with the IRS rules we mentioned or the negative impacts of direct real estate investing. It’s called a “1031 DST Exchange,” and it provides some flexibility within a 1031 exchange strategy.
DST Basics
A 1031 DST exchange, which stands for Delaware Statutory Trust (DST), provides fractional ownership of real estate. The strategy places real estate in a trust managed by real estate professionals on behalf of investors.
When they’re set up in the state of Delaware, there are more advantages due to its pro-business tax laws. Entities incorporated in Delaware, but not operating there, don’t pay state corporate income taxes, but do pay a franchise tax. However, with a 1031 DST exchange, there are no Delaware income or franchise taxes.
You may have heard of something like this before, especially if you’re familiar with Real Estate Investment Trusts (REITs). But while DST exchanges are often compared to REITs, they’re not the same.
DST vs. REIT
In general, REITs buy, sell, and lease unidentified real estate based on a management team’s discretion. Also, REIT investors can buy or sell shares anytime throughout the life of the trust.
Contrary to REITs, DSTs own specific, defined real estate assets. No additional real estate is purchased. Also, the investments are typically held for a multiyear period (often five or seven years), until the real estate assets are sold.
Shareholders in a DST often anticipate their investments to both gain value and produce rental income. Because of these benefits, DSTs have a fixed number of shares to sell. The shares are considered illiquid as they’re held until the conclusion of the investment.
This structure of owning shares instead of buildings makes a 1031 DST exchange an indirect real estate investment, meaning it’s “hands off” and doesn’t require any management. Of course, this also brings about some less-than-ideal consequences (no investment is perfect).
Still, DSTs remain valuable in many scenarios, including legacy planning. Shares of DST investments can be passed to heirs. That can be more beneficial than passing on direct real estate because shares can be divided or sold easily, whereas buildings cannot.
DST investments are also flexible enough that if investors wanted to exchange shares back to a direct real estate holding, they can do it at the end of the DST investment.
There are even more advanced strategies – like the use of an “UPREIT” out of a DST – that are possible with a 1031 DST exchange, though they’re outside the scope of this post.
In the next edition of this blog series, we’ll discuss specific DST exchange investment examples and how they can benefit investors looking to sell.
Securities sold through CoreCap Investments, Inc., a registered broker-dealer and member FINRA/SIPC; advisory services offered by CoreCap Advisors, Inc., a registered investment advisor. Cornerstone Financial and CoreCap are separate and unaffiliated entities.