Finding the ‘Easy Button’ with Delaware Statutory Trusts

By Dwight Dunton

If you like roller coasters, you must be loving today’s real estate investment market. Since 2020 we’ve seen a massive downturn in office properties tied to the pandemic that coincided with a huge upswing in the residential market. Then came the jump in inflation with its corresponding interest rate hikes. And just as inflation seemed to be under control, we have concerns about the effect of tariffs*. It’s enough to make some investors wonder if it’s worth staying in the market.

Despite the downsides, there’s plenty to be positive about in real estate, including a rise in the multifamily market* and signs that the Fed will finally ease up on interest rates. But uncertainty in the industry has given many investors a reason to review their portfolios and see if their properties match their current needs and interests.

As investment property owners age, their perspectives can change, and they’re not as interested in the day-to-day of dealing with tenants, vendors, and banks. But considering that real estate has been good to them, they’re not willing to put it in their rear-view mirror completely and sell out.

That may be why many are searching for ways to shift to a more passive real estate income strategy. The median age of a typical investor is 59*, and as more baby boomers and early Gen Xers shift gears as they enter their retirement glide path*, they’re looking for real estate solutions that make sense for their future.

Trading Up to a Passive Investment

Fortunately, there is a way an investor can simplify their portfolio and reap the benefits of their real estate investments without the hassles and complications. By using a 1031 exchange, one can trade their current investment property for another of equal or greater value and thereby defer capital gains taxes on their profit. The 1031 exchange is a well-known vehicle in the real estate community, and it has benefited many investors.

However, since 1988, 1031 investors have also been able to take advantage of Delaware Statutory Trusts (DST). These are private agreements where a property is held, managed, and operated by one or more trustees who own an interest in the trust property. So the investor sells an appreciated property and defers capital gains taxes through a 1031 exchange, but instead of navigating the complexities of finding and managing an entirely new property on their own, they make an effortless transition into a passive investment.

Every real estate investor has seen a beautiful property in a choice and profitable location and daydreamed about owning it. Using a DST gives them that capability. They could trade a duplex located in an unpopular part of a city for fractional ownership in large, institutional-quality assets that would be far beyond their reach otherwise.

A professional sponsor is responsible for the actual management of the DST property, handling daily operations as well as taxes and distributions. The result is direct ownership in a premium property without the management headaches that can come with it.

DSTs also make sense for investors entering retirement, not only because of their passive income benefits but also their effect on estate planning. Like a standard 1031 exchange, the DST allows for a step-up in the tax basis after an owner’s death. An investor who exchanges a property purchased years ago for $500,000, but is now worth $1 million, has deferred capital gains on the $500,000 profit. But if the investor dies and the DST passes to their heirs, the deferral is still in effect—but with a twist. If the heirs later sell their interest in the DST for $1.1 million, they only owe capital gains tax on the $100,000 profit; the previous capital gains liability goes away.

Another benefit of a DST is that ownership costs are comparatively reasonable. An investment can be made for as low as $100,000. This allows an investor who has exchanged a property worth $500,000 to invest in five different commercial properties to diversify their portfolio. Technically, a DST can be made up of an unlimited number of fractional owners. However, most are capped to no more than 499 by the sponsor to limit SEC reporting requirements.

How to Make a Great DST Investment

There are many factors to consider before investing in a DST. Here are a few that should be at the top of your list:

Who’s the Sponsor?—What’s their track record with DSTs? Ask to speak to other owners to learn their experience with management of the property and to see if it matches up with the sponsor’s description.

Check for Fees—There are fees for buying into a DST, and it’s a good idea to be fully apprised of them before closing. These are usually for sales commissions to a securities-licensed professional and can be in the range of 10% of your equity’s value.

How’s the Property?—If possible, see the property yourself before making a decision. You can rely on the skills you’ve already built as a real estate investor to get a feel for the building’s condition and maintenance costs, as well as the curb appeal to potential tenants.

Don’t Let the “Tax Tail” Wag the Dog—There are times when an investor is so focused on the tax benefits of a DST that they’re unable to see a deal that isn’t right for them. There are occasions where an investor might be better off paying the capital gains taxes and finding a more suitable investment than undertaking a 1031 exchange into a subpar DST with high fees.

There are plenty of details to consider based on your needs and the property you’re considering exchanging, but DSTs do offer an “easy button” solution for investors interested in simplifying their portfolios and gaining better control over their financial legacy without sacrificing returns. If you think you might benefit from a simpler, more diverse portfolio, ask your registered investment advisor or reach out to DST sponsor firms that can give you an outline of how you can participate.