Real estate investors can face challenges as they reach retirement age and focus on estate planning. Often, their real estate holdings have appreciated in value while annual depreciation has reduced the property’s cost basis. Because of this, selling a property before passing away can result in substantial capital gains taxes. However, an investor’s heirs may not be interested in actively managing those real estate properties once the investor has passed away. If suitable, a 1031 Exchange into a Delaware Statutory Trust (DST) may provide a solution to this problem. DSTs allow investors to sell properties without tax consequences, receive potential consistent income from real estate investments, and preserve the eventual step-up in basis upon the investor’s passing.
What is a Delaware Statutory Trust?
A Delaware Statutory Trust (DST) is a legally recognized trust that is established for a business purpose. It is also commonly referred to as an Unincorporated Business Trust (UBO). DSTs are typically formed in Delaware because it is one of the few states that offers a statutory trust law. The IRS approved this structure in 2004 with Revenue Rule 2004-86. The ruling approved qualified DSTs as an investment option for clients seeking to reinvest their 1031 Exchange funds.
Instead of purchasing replacement rental properties, investors can reinvest their proceeds into a Delaware Statutory Trust without paying capital gains tax. Whether the proceeds are invested in one or multiple trusts, each investment is considered an exchange-qualified co-ownership. In other words, in the eyes of the IRS, investing in a DST is the same as buying another 1031 Exchange-qualified real estate property. One of the biggest attractions for investors who are retiring or looking to pass assets to their beneficiaries is that they receive the tax benefits of a 1031 Exchange and monthly income potential without the responsibility of owning and managing another property.
3 Estate Planning Benefits of a Delaware Statutory Trust
Sophisticated investors also recognize that Delaware Statutory Trusts can be useful in estate planning. Implementing a DST strategy allows beneficiaries to avoid capital gains taxes on inherited real estate, minimizes disagreements among heirs, and helps streamline charitable giving.
Elimination of Capital Gains Tax
A step up in basis can eliminate capital gains tax on inherited property
When the investor passes away, estate beneficiaries receive a stepped-up basis for tax purposes. This means that beneficiaries do not pay capital gains taxes on the accumulated appreciation from when the original assets were purchased until the investor passed away. This includes deferred capital gains on real estate that was 1031 Exchanged into the DST. When a beneficiary sells an asset, there is a step up in basis to the value as of the date of the investor’s death. Although capital gains tax on an inherited property can be avoided, assets in a Delaware Statutory Trust are still considered part of the investor’s estate. Normal estate tax rules and exclusions apply. Consult with your estate planning professional to determine how this may affect your estate.
Flexible Distribution of Trust Assets to Beneficiaries
Minimize disagreements on distribution of trust assets to partners & heirs
When beneficiaries receive assets after a loved one passes away, there can be disagreements about what to do with the assets. Some may want to keep them, while others want the distribution of trust assets to beneficiaries to happen as quickly as possible. This is especially true with larger assets, such as real estate investments, that are more of a challenge to divide equitably. A loan could be taken out to buy out the heirs who wish to sell, but it may be difficult to get approved for a loan based on the economy, the performance of the asset, and the applicant’s personal situation. Some investors choose to be proactive in minimizing the potential for these disagreements. By using a DST in their estate plan, they can sell their real estate and divide the proceeds into different trusts. Each of these investments can then be easily identified and distributed to individual beneficiaries. This provides beneficiaries more control over the asset without involving other family members.
Simplified Distributions to Charities
Streamline the distribution and liquidation of trust assets for charities
Delaware Statutory Trusts also make it easier to leave your real estate investments to charity. If you name a charity as the beneficiary of your real estate, it may not have the ability or desire to manage your properties. This could lead the charity to liquidate the property immediately, even if the value is temporarily down due to economic conditions. A quick sale during a downturn minimizes the potential good that your donation can do for the charity. With a DST, the charity can receive your interest in the trust without having to assume day-to-day management of a rental property. It will benefit from the potential monthly stream of income until the sponsors determine the appropriate time to sell the underlying assets. As each property in the trust is sold, the charity will receive your portion of the proceeds.
How a Delaware Statutory Trust Works
DST Property Management
The trust sponsor makes all of the decisions on behalf of all of the trust’s investors. This allows investors to own real estate without the normal headaches and hassle of being a landlord and property owner. These legal entities enable real estate investors to sell their properties and 1031 Exchange the proceeds into the trust. By using a 1031 Exchange, you can avoid paying capital gains on the appreciated value of your real estate. An investor’s money is typically pooled with other investors to purchase larger and/or multiple assets through the trust. These investments are considered to be a direct interest in real estate for purposes of IRS Section 1031. Upon investment, DST owners have the potential to receive potential income from the trust’s underlying real estate assets typically on a monthly basis. However, the trust must keep a portion of its income in reserves because it cannot take on debt or request additional capital once it has closed.
Fractional Ownership of Institutional-Grade Real Estate
Some real estate investors focus on one type of property or in a specific region. This is often due to their expertise, preferences, or proximity to attractive investments. With a Delaware Statutory Trust, your Exchange proceeds are pooled with other investors. This allows the trust to own larger properties than the typical investor could acquire on their own. And because you can invest in multiple trusts, you can pick and choose which strategies, types of properties or geographic regions are best suited to meet your objectives. These trusts offer a wide range of industries and types of properties within their portfolios. Properties may include multi-family or student housing, healthcare, office buildings, storage units, or retail. When evaluating your DST options, inquire about the types of properties that are included in the offering.
Delaware Statutory Trust Taxes
Delaware does not charge a Franchise Tax or income tax on statutory trusts formed in Delaware. The elimination of these taxes reduces expenses, leaving more income potential available to investors. However, all tax obligations are passed through to each investor proportionally based on their investment in the trust. Investors may receive 1099 and 1098 income and interest forms from the sponsor each year based on the portfolio’s performance. An income statement is provided to calculate depreciation for tax purposes. This process simplifies tax planning for your estate because all of the monthly accounting of revenues and expenses is handled for you.
Disadvantages of a Delaware Statutory Trust
Although Delaware Statutory Trusts provide numerous benefits to real estate investors, there are some disadvantages as well. Carefully consider the pros and cons and consult a licensed 1031 Exchange advisor before making a decision about using this strategy in your estate planning.
No Input on Decisions
DSTs are passive investments that are managed by the trust’s sponsor. As a condition of approval by the IRS, investors cannot have operational control or decision-making authority over the underlying properties. A trust sponsor may accept your feedback, but they are not under any obligation to follow your recommendations. Investors who are used to being the final decision maker on their investments may have a hard time letting go of that power and responsibility. However, beneficiaries who are not interested in taking over the family real estate business may appreciate the hands-off approach.
Because you have a fractional interest in the trust, liquidating some or all of your investment is not as simple as listing your individual real estate property for sale. When investing in one of these trusts, you should assume that your investment will remain until the trust’s properties are sold. Unlike the stock market, there is no public market where an investor can sell their interest in one of these trusts.
Moderate to Long-Term Hold Periods
The trust’s sponsors typically take a long-term view of their investments. This requires investors to expect a 5 to 10-year time horizon before being able to access their investment. Most investors in rental real estate properties expect to hold assets for a longer period of time. However, not being able to liquidate early if you need to can be a cause for concern.
Cannot Raise New Capital
Once the trust has closed, it cannot receive any future contributions from current or new investors. Ongoing maintenance and capital improvements must be funded by reserves set aside by the trust. Setting aside reserves reduces the amount of cash available to distribute to investors each month. If there are not enough reserves available, the sponsor may need to liquidate one or more properties to ensure that there is enough cash available to meet the trust’s obligations.
Cannot Be Refinanced
Not all Delaware Statutory Trusts have loans against the properties within the portfolio. However, if there are loans against the underlying properties, IRS rules prohibit refinancing the loans once the trust has closed. This means that the sponsor cannot take advantage if there is a drop in interest rates. Additionally, if a property has a variable rate loan and interest rates increase, the sponsor cannot refinance the loan to lock in a low rate before rates climb even higher. Higher mortgage payments due to rising interest rates could result in reduced cash flow potential to investors. In extreme cases, that property could become unprofitable forcing a sale before it was originally planned.
Austin Bowlin, CPA is a Partner at Real Estate Transition Solutions and leads the firm’s team of 1031 Exchange Advisors & Analysts. Austin advises on tax liability, deferral strategies, legal entity structuring, co-ownership arrangements, 1031 Exchange options and Delaware Statutory Trusts.
About Real Estate Transition Solutions
Navigating the Exchange process successfully can be challenging and complex. For over 20 years, Real Estate Transition Solutions has helped investment property owners navigate and execute tax-deferred 1031 Exchanges, Delaware Statutory Trusts (DSTs), complex real estate investments, and tax planning strategies. Our team of licensed 1031 Exchange Advisors will help you select and acquire Exchange properties that are carefully designed to help meet your objectives.