Delaware Statutory Trusts (DSTs) are becoming increasingly popular among investors seeking to diversify their portfolios and maximize tax benefits. DSTs allow individual investors to participate in a 1031 exchange without the management responsibility of owning the investment property outright.
The use of a DST ownership structure provides investors with a passive investment that generates income and capital appreciation potential. However, the complexities of DSTs can be difficult to navigate and have significant tax implications.
What Is a Delaware Statutory Trust (DST) in Real Estate?
A Delaware Statutory Trust (DST) is a real estate investment vehicle structured as a separate legal entity. DSTs are considered securities under federal law and hold fractional interest in properties, typically commercial real estate. They are treated like direct property ownership for tax purposes, which meet the requirements of like-kind property and qualify as replacement property for a Sec. 1031 exchange.
It is imperative that real estate owners, developers and investors understand the structural intricacies and financial implications of DSTs so that they can reap tax benefits and properly account for the investment.
Breaking Down the DST Structure: How It Works
A DST is an independent legal entity created under the provisions of the Delaware Statutory Trust Act, 12 Del. C. § 3801 et seq. (the DSTA), which provides flexibility regarding its governance, operations and purposes.
Similar to a Delaware LLC or LP, a statutory trust is primarily a creature of contract, governed first by its respective trust agreement and secondarily by statute. In lieu of applying the statutory defaults of the DSTA, Delaware courts will defer to the parties’ rights as agreed upon in a trust agreement. Because of their structure, DSTs, LLCs and LPs also have similar liability protection in that investors are shielded from property-related liabilities.
Under the DSTA, the trust is a separate legal entity, and no creditor of a beneficial owner has the right to possess any of the property belonging to the trust. In other words, creditors cannot go after individual beneficiaries by placing liens against the property. Additionally, DSTs are financed with non-recourse debt and the beneficiaries do not carry any personal liabilities under the loan.
Accounting for DSTs
DSTs are becoming more popular as an alternative for Section 1031 exchanges. It is critical for an entity to understand how a DST would be accounted for under GAAP before proceeding with an investment.
Beneficial Interest
Accounting Standards Codification (ASC) 860, Transfers and Servicing, defines a beneficial interest as “rights to receive all or portions of specified cash inflows received by a trust or other entity, including, but not limited to, all of the following:
- Senior and subordinated shares of interest, principal, or other cash inflows to be passed-through or paid-through;
- Premiums due to guarantors;
- Commercial paper obligations; or
- Residual interests, whether in the form of debt or equity.
Entities must determine whether the DST is a beneficial interest within the scope of ASC 325-40, Investments – Other. Beneficial interests subject to the guidance in ASC 325-40 can be either: (1) beneficial interests retained in securitization transactions and accounted for as sales under ASC 860; or (2) purchased beneficial interests in securitized financial assets.
Variable Interest
If the reporting entity has an interest in an entity, the first step in the analysis determines whether that entity is within the scope of the Variable Interest Entities Subsections in accordance with paragraph 810-10-15-14, Consolidation. If that entity is within the scope of the Variable Interest Entities Subsections, the reporting entity should first apply the guidance in those Subsections.
Variable interests are defined as the investments or other interests that will absorb portions of a variable interest entity’s (VIEs) expected losses or receive portions of the entity’s expected residual returns. Common examples of potential variable interests include beneficial interests.
Derivative
Next, if the DST is not an investment that is consolidated, the reporting entity must assess whether it meets the definition of a derivative under ASC 815, Derivatives and Hedging. A derivative instrument is a financial instrument or other contract with all the following characteristics:
- Underlying, notional amount, payment provision;
- The contract requires no initial net investment; and
- Net settlement.
Furthermore, if the DST is not a derivative, the analysis would then focus on the beneficial interest a debt security under ASC 320, Investments – Debt Securities, or required to be accounted for as one under ASC 860. It should consider factors including, but not limited to the following:
- Involvement of Securitized Financial Assets
- Contractual Cash Flows
- Credit Quality
- Prepayment and Other Settlement Terms
Benefits of Investing in a DST
As mentioned above, DSTs come with tax advantages that make them an effective tool for real estate investors.
Deferring Capital Gains Taxes
One of the primary benefits of investing in a DST is the ability to defer capital gains tax on the sale of appreciated assets. When an investor sells a property outside of a DST, they are typically subject to capital gains tax on the appreciation of the property. Depending on the length of time the property was held and the investor's tax bracket, this tax liability can be substantial and significantly reduce the investor's profits and related cash flow.
However, by utilizing a 1031 exchange, investors can defer these taxes by reinvesting the proceeds from the sale into a DST. Deferring taxes allows investors to:
- Keep more of their profits invested in the DST.
- See greater returns over time.
- Potentially increase their cash flow and net worth, which can be reinvested into additional DSTs or other investment opportunities.
It's important to note that a 1031 exchange has specific rules and requirements that must be met in order to qualify for tax deferral. For example, the replacement property must be of equal or greater value than the property being sold, and the investor must identify potential replacement properties within 45 days of the sale. Investors must also work with a qualified intermediary to facilitate the exchange and ensure compliance with IRS regulations.
Despite these requirements, the potential tax savings can be significant for investors. By deferring taxes, investors can continue to grow their wealth without being burdened by immediate tax liabilities. This can be particularly beneficial for investors looking to build long-term wealth and generate passive income through real estate investments.
Diversifying a Portfolio
A secondary benefit of investing in a DST is the often overlooked but quite powerful strategy of diversifying the asset classes of real investment. With a traditional 1031 exchange, an investor will sell one property and reinvest in another property, maybe two, and will likely be limited to one type of real estate investment (commercial, multi-family, office or industrial).
Investment in a DST offers individuals an opportunity to diversify their real estate investment over a variety of asset classes, thereby minimizing risk and enhancing portfolio stability.
Offsetting Passive Losses with Passive Income
Another tax benefit of DSTs is the ability to offset passive losses with passive income. Passive losses are generated when the expenses of owning a property exceed the income generated by that property. These losses can offset taxable income from other sources, such as wages or other investments.
In a DST, investors receive a share of the income generated by the property, which can be used to offset any passive losses from other investments. For example, if an investor has a rental property that generates passive losses, they may be able to offset those losses with the passive income generated by their DST investment. This can result in a reduction of taxable income and lower tax liability.
However, there are rules and limitations around offsetting passive losses with passive income. For example, certain criteria must be met to be considered a passive investor in a DST, and there are limits on the number of losses that can be offset each year. In addition, specific calculations and reporting requirements must be followed to ensure compliance with IRS regulations.
Despite these limitations, the ability to offset passive losses with passive income can be a significant tax benefit. By using the income generated by their DST investment to offset losses from other investments, investors can reduce their overall tax liability and potentially increase their net income.
Risks of Using a DST
DSTs can also have risks in the form of tax consequences. For example, DSTs are subject to the unrelated business income tax (UBIT). This is a tax on income generated from an investment unrelated to the tax-exempt purpose of the investment. In the case of a DST, the UBIT can be triggered if the property generates income from sources such as parking fees, vending machines or other non-rental sources. It is important for investors to understand the potential for UBIT and factor it into their decision-making process.
Additionally, DSTs may also be subject to state income taxes. Investors who reside in states with high-income tax rates may face a higher tax burden on their DST investment. Consult with a tax professional to better understand the potential state tax implications of investing in a DST.
Let Us Guide You Forward
A Delaware Statutory Trust can be a powerful investment vehicle for real estate professionals, when wielded effectively. It is crucial to enlist a trusted advisor to guide you in capitalizing on all of the opportunities a DST can bring, as well as remaining compliant with accounting standards.
Cherry Bekaert can help your company grow and excel, regardless of the economic climate. Our Real Estate & Construction professionals can tailor a strategic plan to your business goals to cover objectives such as effective tax strategies, structuring developments and profitability analyses. We can help establish strong industry relationships for you, while staying ahead of trends to provide timely and actionable advice. Reach out to your Cherry Bekaert advisor to learn more about how our industry-driven insights can position your business for success.
Related Insights
