You might have heard of people who use accounts and trusts in Delaware to manage their finances. It may seem like a smooth bit of legal maneuvering—and it can be.
The Delaware Statutory Trust, or DST, is an investment vehicle through which holders may pool their resources together and hold real estate.
Why is this a popular investment vehicle for real estate? As you’ll see, there are certain practical benefits when it comes to the management of property and the pooling of resources. But it’s also a convenient way to defer taxes and keep money moving, even after a property has been sold.
The chief benefits of a DST are:
- Passive investing. Investors who want to invest in real estate without being directly involved with the real estate can participate in a DST. Typically there’s one party assigned to manage the property—even if it’s a large property (i.e., a 100-unit building). Investors can participate in real estate investing through a DST without having to do the grunt work themselves.
- Tax benefits. We’ll explain the potential tax benefits (if managed properly) of using a DST later. But suffice it to say, when you handle things the right way, it’s possible to keep the money you have within a DST within the DST and avoid many taxable events that would otherwise require capital gains taxes.
- Liability limitations. The same logic applies to an LLC that owns real estate. If you own the LLC, but the LLC owns the real estate, it’s the LLC that’s exposed to the liability that comes with the real estate—not you. Similarly, with a DST, there will be limited liability incurred as a result of ownership. You would participate in the DST as someone who owns part of the fund, similar to the protections of owning stock in a Delaware-based corporation.
- Strategy. Depending on the needs of the investor, holding real estate within a DST can add diversification to a mostly-stock portfolio, provide stable monthly cash flow, and do it all with a hands-off strategy. It’s up to each investor to decide if this is the strategy for them, but in certain cases, the benefits are obvious.
Before we get ahead of ourselves, let’s dig deeper into DSTs and ask what they are, how they work, and how investors might utilize them:
Defining the Delaware Statutory Trust (DST)
A DST is similar to an LLC or an established family trust in that it can be used to hold title to real estate. However, even though the name includes “Delaware,” investors don’t need to physically be in the state of Delaware to use a DST.
When a DST holds title to a property, multiple investors can invest in it, sort of like a “mutual fund.” The sponsor (or “operator”) has the responsibility of managing the property, as the sponsor is defined as the entity making decisions with said property. Depending on the performance of the asset, including profit generation, investors may be entitled so some shares of said profits. With the DST, the sponsor/”operator” is responsible for decisions that relate to the underlying asset.
Why bother with a DST? If someone were to sell the real estate and turn a profit, they would be subject to capital gains tax on the property. Using a DST means using a “like-kind” property, which means that taxes can be deferred if the investor reinvests into the DST. In other words, the taxes on the capital gains can be potentially deferred with a DST, for example, if the DST then purchases a new property.
1031 Exchange: Understanding the Tax Advantage
The 1031 exchange is a tax-deferred exchange. The basic premise is simple: if an investor doesn’t receive anything from a sale, then there are no capital gains. If there are no capital gains, then there are no capital gains that require taxing.
A 1031 exchange means that the funds within the account remain invested in a new property, ultimately not paying out the proceeds. And without the proceeds going to the owner, capital gains taxes then get deferred until there are capital gains. This process can go on and on—indefinitely if the owner wants—as long as the property sold doesn’t result in capital gains income.
Think of the 1031 exchange as a way to avoid “cashing out” and creating a taxable event. Instead, the money remains within the trust, owning real estate and property that can continue to generate cash flow. However, it’s worth noting that even with a DST, taxable events will still result in having to pay capital gains tax. That’s why it’s worth working with professionals to ensure that everything is done the right way.
How does it work? Realized 1031 notes the following:
- Direct ownership of real estate. DSTs are unique in that federal securities laws view them as securities, but under the IRS tax code, it’s considered a method of owning real estate directly. That’s part of what makes such transactions 1031 eligible.
- LLC tax benefits—not applicable? A DST differs from an LLC on this basis, because for an LLC, the 1031 Exchange would not apply.
- Timeframe. It’s also important to consider the time frame—just how quickly should a DST be invested in another real estate asset? Realized 1031 says: “As previously noted, an investor must find a suitable replacement property, which they know can be financed and ultimately acquired, within 45 days of selling their relinquished property.”
There’s also one challenge worth noting: the size of the new investment has to be sufficient. For example, selling for a large capital gain with one property and turning around and purchasing a smaller property would be insufficient.
What are the Requirements of Investing in a Delaware Statutory Trust?
As you might have noticed, not every retail investor is looking to open a DST. Individuals have to qualify as accredited investors.
According to Investopedia, “To be an accredited investor, a person must have an annual income exceeding $200,000, or $300,000 for joint income, for the last two years with an expectation of earning the same or higher income in the current year. An individual must have earned income above the thresholds either alone or with a spouse over the last two years. The income test cannot be satisfied by showing one year of an individual’s income and the next two years of joint income with a spouse. The exception to this rule is when a person is married within the period of conducting a test.”
A person may also be considered an accredited investor with a net worth exceeding $1 million. This can apply to an individual or the joint net worth of an individual with their spouse. As Investopedia notes, accredited investors may also include general partners, executive officers, and other related combinations for issuers of unregistered securities.
An entity may also be an accredited investor. A private business company with assets exceeding $5 million would apply here. If a business consists of equity owners who are themselves accredited investors, then the entity can become an accredited investor as well. However, forming the organization with the sole purpose of purchasing specific securities is not allowable.
This status allows investors to engage in certain types of investments that don’t work through the usual financial authorities, as Investopedia notes.
Why do investors need to be accredited? It’s typically applied because of the following:
- High net worth. Accredited investors may be high net worth individuals, or otherwise entities with a lot more money than the average person, such as a bank.
- Sophistication. If an investor is knowledgeable about investing, they’re typically granted more leeway. Many regulations and laws are created to protect the average retail investor. For example, someone selling the idea of a DST to ordinary investors may get them involved in something totally inappropriate for that investor’s needs. An investor with more independence, experience, and resources can become accredited and participate in plans like DSTs.
- Investment minimums. According to Fool.com, there may be investment minimums (such as $25,000 into the DST) required to participate.
It’s worth talking to an investment professional if you’re someone who’s considering investing in a DST, especially if you were unaware of the requirements that are listed here.
The Structure of a Delaware Statutory Trust
Given how we’ve defined the DST, what is the basic structure? It wouldn’t be accurate to say that the DST is precisely like holding stock in a public company. These trusts are private and nothing like buying a stock on the New York Stock Exchange. However, that doesn’t mean there aren’t some things that the DST has in common with stock ownership.
For starters, trustees who hold portions of the DST enjoy the protections established by Delaware, which is why the state of Delaware draws so many investments from people out of state. Here are some of the additional considerations:
- Separate legal entity. A DST is a separate legal entity from you, which decreases liability if something goes wrong with the property. Each owner of the trust has an interest in it, similar to being a shareholder.
- Legal protections. With a DST, a creditor of the trust wouldn’t be able to take possession of the property held by the DST. And there are additional protections for revoking a DST, such as the DST being irrevocable if the revoking is done outside the terms of the trust as agreed upon.
When you understand the basic structure, you’ll have a better idea of how DSTs work—and how it might fit within your current plan.
Why Use a Delaware Statutory Trust?
Like many investment strategies, there’s no one single answer. A DST might be appropriate for one investor and be inappropriate for the next. And because of the specific requirements mentioned above, a DST isn’t for everybody.
But for those who are accredited and experienced enough to know how to use a DST—and maximize the benefits it offers—it can be a powerful way to diversify, minimize the tax burden, and grow wealth.