For real estate investors focused on long-term growth, exiting a Delaware Statutory Trust (DST) through a 1031 exchange offers a strategic path to defer taxes, preserve wealth, and maintain investment flexibility.
In this guide, we’ll break down key strategies for exiting a DST, including 1031 exchanges, 721 UPREITs, and cash-out options, so you can align your investment decisions with your financial goals.
What is a Delaware Statutory Trust (DST)?
A DST is a passive real estate investment tool that allows investors to purchase fractional (beneficial) interests in institutional-quality real estate. The DST holds legal title to 100% of these investment properties, while each individual investor receives a proportionate share of operational profit distributions and potential value appreciation generated by the DST properties.
DSTs can be an attractive investment vehicle for the following reasons:
- Passive Income: Potential monthly distributions without operational responsibilities.
- Portfolio Diversification: Access to various asset classes, such as multifamily, office, or industrial properties.
- Tax Deferral Opportunities: DST investments qualify as “like-kind” properties under IRS guidelines, making them eligible for 1031 exchanges.
These features make DSTs an attractive option for investors seeking passive income, diversification, and tax-deferred growth.
Common Exit Strategies for DSTs
DSTs are long-term investments with typical holding periods of 7 to 10 years, during which the property within the trust often appreciates in value. However, when it’s time to exit, investors have several options to maximize returns and defer taxes.
1031 Exchange Out of a DST
One of the most common strategies for exiting a Delaware Statutory Trust (DST) is through a 1031 exchange, also known as a like-kind exchange. This IRS-approved process enables investors to sell their relinquished property and reinvest the proceeds in a like-kind property, deferring capital gains taxes indefinitely. Because DSTs qualify as direct property ownership for tax purposes, they are eligible for 1031 exchanges upon the completion of the DST’s full investment cycle.
Key Considerations:
- Tax Deferral: Investors can continue exchanging properties to defer taxes indefinitely. Upon passing, heirs receive a step-up in basis, potentially eliminating capital gains taxes.
- Reinvestment: Proceeds must be reinvested in a replacement property that meets IRS rules, including matching the original property’s value and maintaining the loan-to-value (LTV) ratio.
Deadlines: Investors have 45 days to identify a replacement property and 180 days to complete the transaction after selling their relinquished property. Most real estate investors hold their DST investment for the program’s full lifecycle, typically five to ten years, and then reinvest in a new DST or like-kind property through a 1031 exchange. This allows them to:
- Continue Deferring Taxes: By reinvesting through 1031 exchanges, investors can defer paying capital gains taxes indefinitely, maximizing their investment returns over time.
- Preserve Wealth: By deferring taxes on capital gains and property appreciation, investors can maintain and grow their wealth over time.
- Create a Legacy: Through continuous reinvestments, investors can pass on the DST to heirs with a step-up in basis, potentially eliminating significant tax liabilities.
When exiting a Delaware Statutory Trust (DST) and reinvesting through a 1031 exchange, follow these steps:
- Complete the DST’s Full Cycle: Wait until the DST completes its investment term and the asset is sold.
- Engage a Qualified Intermediary (QI): The sale proceeds from your fractional DST interest must be handled by a QI to maintain compliance with IRS rules.
- Identify a Like-Kind Replacement Property: Within 45 days of the DST asset sale, identify potential replacement properties, which could include another DST, directly owned real estate, or other eligible investments.
- Reinvest the Proceeds: Close on the replacement property within 180 days of the DST sale to finalize the 1031 exchange and defer taxes on the proceeds.
Cashing Out of a DST
The second potential strategy for exiting a DST investment is through a cash-out, in which investors receive their proportional share of sale proceeds.
While cashing out may be a simple option for some investors, it does lead to tax consequences and other challenges, which may not always be appealing.
If investors decide to cash out, they may be required to pay various tax liabilities upon sale, including federal and state capital gains taxes, depreciation recapture tax on previously claimed deductions, and the Medicare surtax on net investment income for high-income earners.
Depending on the investor, this strategy can trigger significant tax liabilities, which leads some investors to consider the other two most popular DST exit strategies.
721 Exchange (UPREIT Strategy)
While most real estate investors are familiar with the 1031 exchange and cash-out exit strategies, a lesser-known exit strategy for a Delaware Statutory Trust (DST) is the 721 exchange, also known as the Umbrella Partnership Real Estate Investment Trust (UPREIT) transaction.
An Umbrella Partnership Real Estate Investment Trust (UPREIT) is a specialized type of REIT structure that allows property owners to contribute their real estate assets into a partnership with a REIT in exchange for partnership units. These units are often referred to as Operating Partnership Units (OP Units). In return, the property owner becomes a limited partner in the partnership and typically receives REIT shares in exchange for their OP Units.
The term “umbrella” in UPREIT refers to the overarching structure where the REIT serves as the general partner of the partnership, and the contributed properties are held within the partnership. This structure allows property owners to defer capital gains taxes that would otherwise be triggered by selling their properties outright. By exchanging their real estate assets for OP Units, property owners can effectively “roll over” their investment into the partnership without incurring immediate tax liabilities.
Transferring real estate equity into a portfolio has significant benefits, including deferring capital gains taxes from selling the property, receiving dividends from the UPREIT, and enhanced portfolio diversification.
It’s important to note that once you complete a 721 exchange, you can no longer use a 1031 exchange for the same property, as the property is now converted into REIT Operating Partnership (OP) units. However, as long as you hold the OP units, you can continue to defer capital gains taxes. Taxes are incurred at the time you convert the OP units to REIT shares, regardless of whether you sell the shares.
Challenges of Exiting a DST
When a DST property completes its holding period, or “goes full cycle,” it’s typically sold by the DST sponsor, who determines the timing to help maximize investors’ returns. Once the property sale closes, investors must act quickly to reinvest their proceeds into a like-kind property to defer taxes under a 1031 exchange.
This process activates IRS-mandated deadlines, such as identifying a replacement property within 45 days and completing the transaction within 180 days. Additionally, investors must meet requirements like matching or exceeding the original investment value and maintaining a similar loan-to-value (LTV) ratio in the replacement property.
A challenge can also arise when an investor needs to exit a DST before its full cycle is completed. Though DSTs are structured for long-term holding, unforeseen circumstances may prompt investors to exit early. Doing so, however, could impact the tax deferral benefits if the investment was initially acquired through a 1031 exchange. In such cases, limited availability in the DST secondary market or market fluctuations may mean investors have to sell at a discount.
To navigate these challenges effectively, consider working closely with real estate professionals like Qualified Intermediaries (QIs) and tax advisors. Their guidance can help you assess your exit options and the potential tax implications, ensuring a smooth transition in line with your financial goals.
Explore DST Exit Options with 1031 Crowdfunding
When you invest in a DST, you effectively relinquish control of all decision-making power. The DST sponsor assumes responsibility for managing the property and any decisions related to its sale. Given this, it’s crucial to have a clear exit strategy in place before you invest. Planning your exit upfront allows you to navigate the potential challenges and constraints associated with DST investments, including termination notices, tax implications, and market conditions.
Whether your exit strategy involves a 1031 exchange, cash-out, or 721 exchange, understanding the costs and aligning your approach with your broader financial goals is essential. By planning ahead, you’ll be better prepared to execute your exit on your terms when the time comes.
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Our team of experienced professionals is here to guide you through every step of the investment journey—whether you’re entering or exiting a DST. Start by planning your exit today and invest with confidence.
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This material does not constitute an offer to sell or a solicitation of an offer to buy any security. An offer can only be made by a prospectus that contains more complete information on risks, management fees, and other expenses. This literature must be accompanied by and read in conjunction with a prospectus or private placement memorandum to fully understand the implications and risks of the offering of securities to which it relates. As with all investing, investing in private placements is speculative in nature and involves a degree of risk, including loss of your principal. Past performance is not necessarily indicative of future results, forward-looking statements and projections are not guaranteed to achieve the results described, and your actual returns may vary significantly. Investments in private placements are illiquid in nature, and there may be no secondary market or ability to sell the investment should the need for liquidity arise. This material should not be construed as tax advice, and you should consult with your tax advisor, as individual tax situations will vary. Securities offered through Capulent, LLC Member FINRA, SIPC.
