As an investor, you should always be thinking of your long-term strategy. When an investment is no longer profitable or does not fit your needs, you may be considering a plan or strategy to exit. In the case of a Delaware Statutory Trust (DST), this situation may occur when the DST comes full-cycle, which varies but is generally within a five-to-10-year period.
At the end of the cycle, the DST must dispose of the assets it purchased on behalf of investors to return their principal and any appreciation experienced by the underlying property. Individual investors must then decide how they will exit the DST. This guide discusses how DSTs work, what an exit strategy is, and the options you have.
What Is a DST?
A Delaware Statutory Trust is a legal entity created under Delaware statutory trust law. This law enables a more flexible approach to how the entity operates. Investors, also known as beneficiaries, own a pro rata, or fractional, interest in the trust, which allows them to receive distributions from the trust’s underlying properties, such as rental income or sale of a property.
DSTs are generally created by real estate companies, known as sponsors, who identify and acquire assets using their own capital and place them under trust. During an offering period, beneficiaries can purchase their fractional shares and become passive investors. This means they do not have to manage the property but maintain an equitable title. The Internal Revenue Service (IRS) considers these interests as direct property ownership, meaning those involved in DSTs are eligible for 1031 exchanges upon entry and exit.
What Is an Exit Strategy in a DST?
In investing, an exit strategy is a plan of action to remove oneself from a situation, and it may be necessary for differing reasons. For example, under favorable market conditions and circumstances, investors will look to exit after a DST has gone full-cycle and may seek other investments with the income and gains earned. When market conditions become more challenging, a strategy to exit may be developed to limit losses.
Today, DSTs are commonly used for exchanges. DSTs qualify as replacement property for 1031 exchanges when exchangers acquire a beneficial interest in the trust. Additionally, most DSTs dissolve in such a way that exchangers can complete a 1031 exchange upon their exit from the trust. To do this, the real estate asset(s) must be sold.
Almost all potential exit strategies involve selling the real estate assets. Therefore, the DST fund managers have a responsibility to acquire properties that will produce income during the life of the fund and maintain resale value so the exit strategy can be accomplished in the stated timeframe. To do this, managers must know the types of potential buyers their properties will attract and then how to manage the property in a way to attract those buyers.
Because DST portfolios generally contain one or more real estate properties — some of which are high-value, investment-grade commercial properties — potential buyers of these properties typically include various entities and investors, such as:
- Pension plans
- Ultra-high net-worth individuals
- Other real estate investment funds
- Real estate investment trusts (REITs)
These types of buyers have specific requirements for the properties they consider acquiring. DSTs often have similarly rigorous requirements and generally aim to acquire high-valued, investment-grade properties that will increase in value over time, maintain their appeal to potential buyers, and be sold according to the exit strategy.
As an alternative to selling the real estate assets, as we mentioned in our blog on 721 exchanges, some DSTs may utilize an exit strategy that disposes of their property by contributing it to an Umbrella Partnership Real Estate Investment Trust (UPREIT) in exchange for units of interest in the UPREIT. DST beneficiaries, in return, exchange interest in one property for interests in a large portfolio of properties on a tax-deferred basis.
Whether a DST plans to sell or contribute its property at the completion of its cycle, it is important for you to know the expected exit strategy, so that you are sure to be left in a position to make whatever future investments you have planned.
The Three Most Common DST Exit Strategies for Investors
Once an investment has gone full-cycle, investors need to consider their next move in their long-term strategy. There are three common exit strategy options, which we cover below. However, remember that each of these strategies has benefits and drawbacks, so it’s important to carefully weigh your options and speak with an expert before making your decision.
The first strategy is cashing out, in which investors receive a portion of their capital contributions.
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. This is because the cash-out transaction must comply with the Rev. Rul. 2004-86 set by the IRS, a ruling that allows investors to defer tax on the initially invested amount under section 1031 of the Code for DST investment.
If an investor decides to cash out, they may have to pay the following tax liabilities upon sale:
- Federal capital gains
- State capital gains
- Depreciation recapture tax
- Medicare surtax
Depending on the investor, this strategy can trigger a significant taxable event, which leads some investors to consider the other two most popular DST exit strategies.
You can also exit a Delaware Statutory Trust through a 1031 exchange. Also referred to as a like-kind exchange, this IRS-approved process is familiar to many investors and enables them to defer the capital gains taxes or the tax liability on the sale of an investment property. Because DSTs are considered direct property ownership for tax reasons, investors are eligible for this strategy following a DST investment full-cycle event.
Because this section of the code only defers the capital gains tax that would otherwise be recognized in a sale outside of a 1031 exchange, some investors decide to exchange their properties — and continue to exchange them over and over — instead of selling them. Through this process, investors can engage in a series of exchanges for years until they pass away, at which point the DST may be transferred to their heirs at a step-up in basis.
Planning an exchange exit from a DST empowers investors to build wealth over time through their real estate investments while deferring capital gains tax. Of course, to be eligible for this exchange, the proceeds from selling the relinquished property must be immediately reinvested into a like-kind replacement property using a qualified intermediary (QI) to handle the funds. This means the property must be of equal or greater value, and the investor must complete the exchange within 180 days of closing on the relinquished property.
This exit strategy enables you to defer capital gains tax indefinitely and grow your wealth faster. However, keeping your capital in real estate means you cannot access it. It also means you must meet the strict requirements of a 1031 exchange, such as using a qualified intermediary (QI) and meeting the deadlines for identifying and closing on the replacement property.
Some potential risks of entering into a 1031 exchange may include:
- Interest rate risk
- Loss of management control
- No guarantee of projected appreciation
- No guarantee on monthly distribution amounts
The third potential strategy for exiting a DST investment is through a 721 exchange into an UPREIT structure. Under Section 721 of the Internal Revenue Code, real estate investors can contribute their physical property to a partnership on a tax-deferred basis in exchange for interests in that partnership without entering another 1031 exchange. This exchange is done at the discretion of the trustee and may or may not require consent from those invested in the DST.
Once the investment property goes full-cycle, an investor can use a 721 exchange if a REIT purchases the real estate. Depending on the situation, this may be mandatory or optional. Essentially, the larger REIT Operating Partnership (OP) will absorb the DST investment.
REITs often hold real estate through these OPs that allow holders to exchange property for an economic interest in the REIT. The OP units have economic rights — the same as the rights to the shares — of the REIT. After a certain amount of time, they can be converted into REIT shares for liquidity in a taxable transaction. Alternatively, investors can keep the units until they pass, which then sets up a step-up in basis for their heirs.
Once an investor proceeds with the 721 exchange, however, they will lose the ability to continue deferring taxes through a 1031 exchange. This means their only option is to convert their OP units to REIT shares and pay the resulting tax if they can liquidate from the REIT.
A major benefit of a 721 exchange is that it allows investors to divide their OP units for estate planning and give their heirs a step up in tax basis — ultimately eliminating any deferred capital gains tax. This is why investors in the early phases of their estate planning may consider a 721 exchange.
Learn More About DSTs With 1031 Crowdfunding
As you can see, there are plenty of ways to extend your investment process following a full-cycle investment in a DST. If you decide that a 1031 exchange is the right fit for you, consider how 1031 Crowdfunding can help you through the process. We offer an extensive online marketplace of 1031 exchange eligible DST properties, helping you find the right replacement property within the required period and streamlining your exit strategy.
At 1031 Crowdfunding, we’re also proud to offer support from our expert team. We can help you comply with DST and 1031 exchange requirements, provide professional advice, and assist you in building an investment portfolio that suits your needs and goals. Register for an investor account today to learn more about DSTs and access our turnkey solutions.
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.
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