Delaware Statutory Trusts for 1031 Exchange Investments

Delaware Statutory Trusts (DSTs) are extremely popular with 1031 exchange investors because they allow diversity in an investment portfolio. In addition, 1031 exchange investors favor DSTs due to the fact that it can be difficult to identify a replacement property within 45 days of sale and they have certainty of a closing within the applicable 180-day window.

Delaware Statutory Trust Investments (DSTs) have flourished as real estate investments over the past decade. They are an outgrowth of the older Tenant-in-Common (TIC) investments but don’t have some of the burdensome requirements of a TIC investment. In particular, TIC investments require the unanimity of all the co-investors to agree on any actions and that is often difficult to achieve.

What is a Delaware Statutory Trust?

The reference to the term DST does little to describe such an investment. Rather, the term describes a simple mini-type trust that is available to establish in the business-friendly state where it originated. The use of the DST structure helps keep title clean in connection with ownership by many co-investors. It separates the investor holding title individually to holding in a new trust where the investor is the beneficial owner. The trustee of the trust can take actions on behalf of the trust beneficiaries (i.e. the DST investors/owners) which does not require agreement by all. One challenge of a DST structure is that the property cannot be refinanced after the initial loan is in place nor can a lease be revised for a single tenant property. These factors are usually dealt with before the DST formation but sometimes the issues may arise later. If so, solutions can be complicated.

Why invest in a DST?

A DST is attractive to an investor who desires access to a single property or portfolio of high value, high quality real estate asset(s) that may not otherwise be available to them due to size or service constraints. The investor receives a deeded fractional ownership in the property in a percentage based upon the equity invested. It has some characteristics of a REIT or Real Estate Investment Trust but is different, including the fact that it is often, but not always, just a single property. In addition, the owner of REIT shares holds a partnership interest in the underlying real estate investment. Partnership investments do not qualify for 1031 exchange investments, even if the underlying asset consists of real estate.

These investments generally pay quarterly an amount based upon the excess rent over the property expenses, including any mortgage payments. The rate of return varies from deal to deal based on the specifics of the property and financing. Typically, the sponsor knows the net rent that can be expected and can give the investor the anticipated return for the term of the investment. The holding period of the asset is usually 5-7 years and the investor shares in the same percentage basis the appreciation in value upon sale of the property. This can increase the overall annualized return a couple of percentage points.

The manner in which DSTs are marketed to the public have a lot of characteristics of sales of securities. Over time, the SEC decided to regulate them as actual sales of securities. So, although a DST interest retains the nature of real estate ownership, with some exceptions, they are regulated. They are typically brought to market for syndication by large well-known sponsors, although they have to be acquired through a Broker, Registered Investment Advisor or a licensed Financial Advisor. If a consumer does not have one, the sponsor will usually refer him or her to a few to work with. The broker or advisor must have an agreement in place with the sponsor and not all brokers or advisors have agreements with all sponsors. Typically, the broker or advisor will vet all offerings of the sponsors with whom they have an agreement and that level of due diligence is a benefit to the investor who is unlikely to have the wherewithal to review the investment as closely. All fees are paid by the sponsor and not the investor.

Delaware Statutory Trust Pros and Cons

DSTs are popular to people in general who generally wish to have some diversity in their investment portfolio by introducing some real estate component. People like being able to count on the specific return and appreciate not having to deal directly with tenants. They are also extremely popular with 1031 exchange investors for the same reasons but also due to the fact that it can be difficult to identify replacement property within 45 days of sale of their relinquished property and they have certainty of a closing within the applicable 180-day window. Most investments include picking up a pro-rata amount of underlying debt on the property, an important factor for 1031 exchange investors. The debt is non-recourse to the investor but allows the investor to hold new debt equal to or greater than the debt retired upon sale of the relinquished property. A DST or two make this very easy. The transfer of the relinquished property to the Qualified Intermediary, and the receipt of the replacement property from the Qualified Intermediary is considered an exchange. To be compliant with IRC Section 1031, the transaction must be properly structured, rather than being a sale to one party followed by a purchase from another party. Exchange investors also sometimes use a DST as a backup in case the primary identified property falls through or the primary property acquisition does utilizethe entire exchange value. The DST purchase can absorb the balance.

Like any investment, DSTs have risks associated with them. The sponsor does due diligence as does the back office of the broker or adviser’s firm, but so should the investor. The prospectus typically does a good job in pointing out other risks of each such individual investment. Also, they are somewhat illiquid once acquired, so the investor should be prepared to stay invested for the term of the deal.