Last week I had paid a visit to Trevor’s office building, Metropolitan Square, located in Houston, Texas. Trevor was carrying out some maintenance work in the building. Trevor Buchanan is a businessman and master real estate investor. Trevor has seven investment properties under his name, and Metropolitan Square is one of them. The three-floor building has corporate offices on every story. Trevor had leased the building to ten tenants, who run their businesses there. Though the property was generating good income, managing it would require a considerable amount of time.
Trevor was complaining about the untimely calls he would get from his tenants for repairing the property. ‘They call for almost everything.’ he was saying. He was telling how painful it is to manage an investment property and why an investor should choose to sell their property because of rising maintenance load.
Trevor was planning to sell Metropolitan Square, and that’s why he had called me. ‘I want to sell this property. I will reinvest a part of the proceeds in some other real estate and keep some cash for later.’ Trevor was clear in his mind. He wanted to sell Metropolitan Square and reinvest the proceeds into another real estate. I had been researching on 1031 exchanges for the past eight months. I thought it would be perfect for Trevor.
‘Why don’t you go for a 1031 exchange? You won’t have to pay taxes then.’ I suggested. ‘But I don’t want to reinvest my entire sale proceeds in one real estate, and as far as I know, you must reinvest the entire proceeds to qualify for a 1031 exchange.’ Trevor had done his research as well. However, it was incomplete. The IRS requires the investor to reinvest their entire sale proceeds to qualify for a 1031 exchange. However, it does not need to be a single real estate. Investment structures like DSTs and TICs also qualify for a 1031 exchange.
We found DSTs to be suitable replacement options.
Delaware Statutory Trusts (DST) are old investment strategies. However, the current tax laws have made them a suitable investment option for passive 1031 exchange investors as well as direct (non-1031) investors. DSTs are separate legal entities, created as trusts that qualify for a 1031 tax-deferred exchange.
DSTs are managed and regulated by trustees or sponsors. These sponsors acquire investment-grade properties under a DST umbrella and then allow investors to buy fractional ownership in those properties.
In 2004, the IRS in its Revenue Ruling acknowledged a DST investment structure eligible to qualify as replacement property for 1031 Exchanges. The Revenue Ruling (Rev. Ruling 2004-86) allows DSTs to have up to 100 investors or even more as beneficial owners of the property.
Benefits of DST Investment –
Freedom From Management Responsibilities
Like Trevor, there are hundreds of investors who don’t want to bear the burden of day-to-day management responsibilities. Using a 1031 exchange, you can trade your current investment property for a fully managed co-owned real estate.
The majority of investors look for pre-arranged and non-recourse financing with easy approval. You can invest in properties ranging from debt-free acquisitions to properties with up to ~85% leverage.
Steady Flow Of Income
One of the biggest benefits of real estate ownership is the steady flow of income. When looking for a fixed income, there could not be a better choice than DSTs. A DST distributes 90% of its income among the beneficiaries.
Diversification does not protect your investment against losses. However, you can use real estate to diversify your investment portfolio for accumulating wealth and generating income. Sometimes, an investor may look to diversify their real estate holdings so that they don’t need to concentrate on one property or location. A DST investment is a great way to diversify your investment portfolio.
DSTs usually have large institutional-grade properties in their portfolio. Owning such properties requires enormous funds. However, you can co-own an institutional-grade property along with other investors in a DST.
Helps To Avoid “Boot”
If your replacement property costs less than the relinquished property, it results in a boot. ‘Boot’ is the difference between the costs of the replacement and relinquished properties. Boot eliminates the possibility of a 1031 exchange. To avoid boot, you can invest the leftover money in a DST and qualify for a 1031 exchange.
Just like you, I told Trevor about these benefits of DSTs. A DST investment is the best strategy if you want to invest your sale proceeds in more than one real estate and still qualify for a 1031 exchange. However, if I say DST investments are risk-free, it will be a lie. Like any other investment, DSTs also have some drawbacks.
Risks Attached To A DST Investment –
- Undoubtedly, doing a 1031 exchange into a DST has many benefits. However, in case you fail to meet the IRS requirements, you may end up paying heavy unwanted taxes and investing in a DST presents additional tax risks.
- A DST investment is highly illiquid because there is no national market where investors could their interests. A DST investment requires a long term commitment, and you should be prepared for this.
- DSTs have high processing fees, and expenses associated with the purchase and ownership of a DST could also be higher. In rare cases, these expenses may outweigh the benefits of 1031 exchanging into a DST.
- As the trustees take all decisions related to a DST, conflicts of interest may arise that could adversely affect the investment.
You could be exposed to any of these risks when investing in a DST. That’s why you must speak to your advisor or a 1031 exchange expert before planning your investment. I had given the same suggestion to Trevor as well. I hope, like him, you will also be able to reap the benefits of a DST investment.