The ABCs of DSTs and 1031 Exchanges – Part 1

Section 1031 Tax-Deferred Exchanges have given investors a lot of reasons to continue to place their resources into investment real estate.

Exchange transactions provide leverage to potentially increase the taxpayers’ return on their capital investment along with the tax advantages of depreciation and deferring capital gains taxes through

But what happens when the investor is tired of dealing with the 3 Ts—tenants, toilets, and trash?

If they are tired of the time-consuming management headaches related to their real estate investment, they can either purchase a NNN  (triple-net) piece of real estate property, or they can acquire a fractional interest in a DST, Delaware  Statutory Trust.

Both of these options allow the taxpayer to defer paying their taxes and leverage the use of their equity, with the goal of having little or no management headaches.

Parts One and Part Two of this missive will discuss some of the advantages and disadvantages of  Delaware Statutory Trusts (DSTs).

SO THEN, WHAT IS A DELAWARE STATUTORY TRUST (DST)? 

A DST  is a type of real estate investment that provides the taxpayer with a fractional ownership interest in commercial investment properties that can be significantly larger than what the taxpayer would have been able to obtain on their own.

Examples of these passive professionally managed investments are Industrial Buildings, Multi-Family Apartment Complexes, Health Care Facilities, Medical Offices, Office Buildings, Hotels, Self-Storage Facilities, and other types of commercial real estate.

What the investor obtains is a fractional interest in the DST property.

WHAT ARE THE RISKS ASSOCIATED WITH DSTs?

As a generalization, DSTs have many of the same risks as owning real estate just by oneself. BUT because of how a DST is structured, there are additional risks that probably do not exist when directly owning a property.

Some  of these risks are:

• REGULATIONS:   There are various regulatory restrictions from IRS in order to take advantage of Section 1031 exchanges.  Remember that our tax laws always seem to be fiercely debated and often “changed” by Congress.  There are also Security and Exchange Commission (SEC) regulations that need to be complied with.

• EXECUTION OF DOCUMENTATION:  DSTs involve a number of different people with different goals, which also must comply with following our changing laws. So, the putting together of a DST package is a pretty complex process.  Just one mistake by the sponsor (the party that has put the  DST package together) or their legal or financial counselor, or the Qualified Intermediary (QI), could result in the Section 1031 Tax-Deferred  Exchange becoming non-qualified for Section 1031 purposes.

• HEALTH OF THE ECONOMY: The health of the economy in the  United  States can play a major role in how the DST performs economically.  What happens when the interest rates rise or for that matter, what if there is an economic disaster, for example, Covid-19 or a Mortgage  Foreclosure Crisis like the United States had in 2008-2012, etc.?

• TYPE OF ASSET RISKS:  Certain types of investment real estate can be subject to different economic risks and pressures;  for Example:

1. OFFICE BUILDINGS:  There are increased vacancies during economic downturns and pandemics.
2. HOTELS:  Location, Location, Location—what happens if the major highway has been moved or traffic flows are changed?  In many cases, the income streams are seasonal. What if the hotels obtain most of their income from business conferences and there is a  governmental lockdown.? Obviously, the Covid-19 Pandemic has not helped that industry.
3. MANUFACTURING:  What if the needs for the product produced have been reduced?  What if the necessary supplies to make the product become unavailable?
4. MULTI-FAMILY HOUSING:  What if the tenants can’t pay due to their jobs being lost (i.e., Pandemic) or the job market has changed, or a factory that supports the area has closed down?

WHAT FEES AND COSTS ARE INVOLVED? 

There are a number of fees that can be charged at three different levels; upfront fees, operating fees, and resale fees.  The following are some of those fees and costs:

• SALES COMMISSIONS:  Usually, DSTs are sold by independent third-party selling companies. They, of course, get paid a commission when a DST investment is sold.
• BROKER-DEALERS:   The Managing Broker-Dealer gets a fee for managing the property, but in many cases, also gets reimbursed for their costs related to their due diligence and marketing efforts.  Because DSTs are classified as securities, DSTs are offered to the public through legal entities known as “managing broker-dealers.”  These broker-dealers generally assist in document preparation, SEC compliance, and due diligence and, as a result, are compensated for this work.
• WHOLESALING:  Most Sponsors (the company that puts the entire DST product together) have their own selling teams, also known as wholesalers.   The wholesalers work with other registered representatives (salespeople), furnishing them with the information and documentation necessary to make the sale.   Most of these wholesalers are assigned a geographical area to be responsible for, and they, too, will receive a commission for the transactions that occur within the geographical area that they are responsible for.
• ACQUISITION FEES (A/K/A “FINDERS FEES”):  These fees are made to the Sponsor for negotiating, identifying, and procuring the asset for the DST.  Sometimes the Sponsor also gets paid for helping to secure the financing for the acquisition.
• OTHER COSTS:  There are items called “front load” costs.  These are funds needed for reserve accounts and other capital costs.  Front Load costs are an important item to be aware of because when you are trying to re-sell your undivided interest in the DST, you will need to recover those additional costs, as well as the sponsor’s asset management fees and fees related to the final sale of the DST Property.

WHAT HAPPENS ON THE RE-SALE OF THE DST INTEREST? 

That is one of the most important questions.  What happens when someone wants to resell or, for that matter, is forced to re-sell due to needs, death, divorce, etc.?

Some Sponsors will try to help the investor find a purchaser for the investor’s fractional interest.  Some “Professionals”  believe that Sponsors have no incentive to resell an individual fractional interest because when there is a resale of the entire DST property, the Sponsor then has a large group of investors who are ready, willing, and able to get into another DST, which of course, means a new set of commissions, etc.

We will cover in Part two of this DST  missive how to re-sell the DST fractional interest and the Pros and Cons of DST ownership—look for it !!

AFFILIATED 1031, LLC always recommends that the taxpayer should consult their tax and/or legal counsel on all matters dealing with the Internal Revenue Service.