by Diana Hill, Online Trading Academy
Article of the Week from Online Trading Academy
While many investors are familiar with the concepts and perhaps the benefits of 1031 exchanges, they may have concerns about the additional work required and the unknown of new property. There are options for 1031 exchanges, however, which can almost eliminate management, produce a consistent return and provide the tax deferring benefits of an exchange. A DST (Delaware Statutory Trusts) is one such option that has been gaining in popularity, in part due to preferential tax treatment.
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Before we dive into what a Delaware Statutory Trust is, let’s define 1031 exchange. A 1031 exchange gives real estate investors the ability to defer paying capital gains taxes on the sale of a property, if they purchase a like-kind property with the profits gained on that sale. The IRS has specific rules which govern 1031 exchanges. Some of those rules relate to the time frame in which a like-kind investment/property needs to be identified along with how the proceeds from the sale of the property need to be managed. Be sure to understand these rules prior to doing a 1031 exchange. However, for those real estate investors who are looking for minimal management responsibilities, the sale profits could be used to invest in a Delaware Statutory Trust.
What Is a Trust?
A common law trust is simply a law that was created to allow a person to hold legal title to property or assets for the benefit of another. They have become a way to pass ownership of assets from one generation to another.
Through my experience in the field of probate investing, I’ve dealt with trusts over the years. I recall a conversation I once had where the individual I was talking with was insistent that the number of probates would be reduced substantially because of a new thing called trusts. I was polite but had to giggle because trusts were first developed in the 12th century and were not new at all. Historically, trusts have been used by the wealthy, but they became much more mainstream about 50 years ago. The more widespread use of trusts is probably what the individual I was speaking with was referring to.
In addition to common law trusts, savvy legal minds have taken trusts a step further and created trust vehicles for all kinds of purposes. An example is a statutory trust used for businesses, which incorporates the common law concept with the requirements of filing with the secretary of state.
What is a Delaware Statutory Trust?
The Delaware Statutory Trust Act, enacted in 1988, made business trusts (now called Statutory Trusts) recognizable as their own legal entity. This gives the trustees much more freedom in how the entity is structured, allowing them to make it more beneficial for all parties involved. When these trusts are set up in Delaware they come with some additional advantages.
Delaware is known as a great state to incorporate in because of its business-friendly tax law. Businesses that are formed in Delaware but do not conduct business there, do not need to pay state corporate income tax (though there is a franchise tax). However, Delaware Statutory Trust has no Franchise Tax and no Delaware income tax.
How a DST Works
A DST is formed and managed by a Sponsor, a company or group of real estate professionals that will invest, manage and administer large scale real estate assets on behalf of the investors in the trust. These kinds of large-scale investments use to be limited to REITS, Insurance Companies and so on. Now that these investments can be used as replacement property for 1031 exchanges, it gives the individual investor an opportunity to participate in the ownership of assets they otherwise couldn’t purchase on their own.
When considering doing a 1031 exchange using a Delaware Statutory Trust, there are some benefits and drawbacks.
Benefits of a Delaware Statutory Trust
- 1031 exchange (defer capital gains)
- Able to still hold real estate but with less hands-on management
- Beneficial owners can have the same limitations on personal liability for the entity as shareholders of a Delaware corporation
- No State Income Tax on a Statutory trust formed in Delaware
- May Qualify as a REMIC (Real Estate Management Investment Contract) or REIT (Real Estate Investment Trust)
As you can see by the list of benefits, a DST provides the investor with an opportunity to use sophisticated trust and tax laws to build wealth and decrease hands on management. There is no doubt that when some investors enter a later stage of life, these advantages and the ability to secure a legacy can be a driving force. A Delaware Statutory Trust can help facilitate those goals. If DST is a silver bullet for real estate investors, why isn’t everyone investing in them? There are some drawbacks.
Drawbacks of a Delaware Statutory Trust
- Lack of Liquidity – holding period of typically 5-10 years
- Requires a sizeable investment, 100k and above
- Investors must do their due diligence on finding a reputable company to invest with (preferably on that has been in business for a decade or longer)
Implementing a DST through a 1031 exchange is a complicated and time sensitive process. Investors shouldn’t begin the process without some forethought and substantial planning but, if the benefits fit with their goals and the drawbacks are of little concern, this might just be a real estate investment to consider.
For those interested in a DST, the next steps would be to speak with a Broker to value the property they’ll be selling and then talk to a tax advisor to calculate the tax benefits. If the numbers align, they can then start looking for the right sponsor to invest with.
What to Look for in a DST Sponsor
- Asset illiquidity
- Area vacancies and the general market conditions where the properties are held
- Solid operating history
- What interest rate risks might be incurred
- Risk of rental rates softening or new supply coming to market
- What kind of leases do they have: short term, long term, Single Net Lease (N Lease), Double Net Lease (NN Lease), Triple Net Lease (NNN Lease), Absolute Triple Net Lease, Modified Gross Lease
- General economic risks
- Leadership
Learning how to use these vehicles is what separates you as an investor. Always make sure you work with your professionals.
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