If you hold highly appreciated real estate assets and are looking for ways to minimize or defer your taxes, you have probably heard the abbreviation “DST.” Not sure what it is or how it works? As there are two very different and increasingly popular financial strategies that both use the acronym DST: Delaware Statutory Trusts and Deferred Sales Trusts, let’s break down the differences and the pros and cons of each.
Delaware Statutory Trust
Delaware Statutory Trusts are primarily used by investors who wish to diversify their real estate holdings and defer capital gains tax on real estate by using a 1031 exchange. A group of up to 100 investors pool their resources to invest in large, commercial real estate. All of the investors have an interest in the trust which owns the underlying asset. The master tenant, or real estate sponsor firm, purchases the property and opens up the trust for investors to purchase beneficial interest. Interested investors can either purchase beneficial interest directly, or deposit 1031 exchange funds into the trust.
Benefits of a Delaware Statutory Trust
One of the primary draws of the Delaware Statutory Trust is that it is a hands-off, passive, real estate investment. For investors who are tired of managing tenants, making repairs, and always being on call, it is an appealing option. The real estate is managed entirely by the master tenant.
Another draw is that it allows investors to diversify their holdings, and divide their investments among various real estate properties, thus providing a layer of security.
Finally, for the investors using proceeds from a 1031 exchange, it is a way to defer capital gains taxes. Rather than having to find a single property that meets the requirements for a 1031 exchange, investors can own a stake in an apartment building, a large medical complex, or even a shopping center–real estate investments that would be inaccessible as a single purchaser–and still defer taxes.
Drawbacks of using a Delaware Statutory Trust
While a valuable investment and tax strategy, Delaware Statutory Trusts are not without drawbacks.
Like other real estate investments, when using a Delaware Statutory Trust, you are still subject to high vacancy rates, loan defaults, and the fluctuation of the market.
It is important to carefully vet any prospective controlling partner/sponsor. There are plenty of unscrupulous people in the business who can leverage the trust for their own benefit. For example, if you read through the prospectus of many trusts, you will find that the trust purchased the properties from the owners of the trust themselves. However, it is impossible to tell if the property was purchased at fair market value before being sold to the investors of the trust, or if the price of the property was inflated to benefit the sponsor.
While investors in a Delaware Statutory Trust get to enjoy a passive real-estate investment, the flip side is that you are a passive participant, and the investment is controlled by the master tenant. It is common for 6%-15% of the gross proceeds to be deducted from your returns as fees for the operator. Even with fees, it is possible to make a profit if you are willing to stay the course for seven to ten years until the sponsor decides it is time to sell.
Deferred Sales Trust
The other DST, a Deferred Sales Trust, is a special form of an installment sale. Instead of selling directly to a buyer, the investor sells their highly appreciated asset to a third-party trust, who gives the investor a promissory note in exchange. The trust then sells the asset to a buyer and collects the proceeds.
In a sense, the investor now acts as a lender to the trust. As long as the investor doesn’t collect proceeds, they don’t owe capital gains taxes. The trust can reinvest the proceeds on behalf of the investor, and the investor can collect interest from their investments, or the profits from the sale in installments over time.
Benefits of a Deferred Sales Trust
A Deferred Sales Trust is an effective way to defer capital gains taxes without a 1031 exchange, while maintaining the flexibility to invest profits and receive payments in a way that best serves your financial needs and goals.
Unlike a Delaware Statutory Trust, a Deferred Sales Trust can be used with any highly appreciated asset – not just real estate. If you currently own highly appreciated real estate, a Deferred Sales Trust can be used to reinvest your profits in a diversified portfolio, without the narrow requirements of a Delaware Statutory Trust or a 1031 exchange, and still defer taxes.
Like a Delaware Statutory Trust, a Deferred Sales Trust can be an entirely passive investment. If you want to move on from active real estate management or retire from a business you own, a Deferred Sales Trust is a good way to leverage your wealth for residual income.
With a Deferred Sales Trust, you have the ability to structure payments to give you the liquidity you need now, but also invest proceeds to provide you an ongoing passive income stream.
Drawbacks of a Deferred Sales Trust
A Deferred Sales Trust requires a team of experts and professionals to set up correctly. You will want to find a trusted and experienced Deferred Sales Trust trustee, and the trustee has to be a truly independent third-party. You will also want the assistance of CPAs and financial advisors to structure the trust in a way that meets your financial aspirations.
Which One Should I Use?
For investors who want a strategy for real estate capital gains tax deferral, both DSTs fit the bill. Both DSTs are frequently used by real estate investors who want a truly passive investment. They are ideal for those looking to trade in managing tenants and toilets for travel and freedom. The one you decide to use should depend largely on your financial goals, the level of control you want to exercise, and your risk tolerance.
Real estate investors who want to utilize a 1031 exchange frequently choose a Delaware Statutory Trust. It allows greater diversification and requires less management responsibility. The risk is divided among many investors, and it can be a good bet as long as you choose a sponsor firm that is trustworthy and reliable.
Investors who also want diversification, and potentially want to get out of real estate all together often prefer a Deferred Sales Trust. Perhaps, they want to stay in real estate, but want to have more control over the properties that they reinvest in. A Deferred Sales Trust is best for investors who want greater flexibility and more control. Many investors who want to sell when the market is high and then wait to reinvest when the market is low will choose a Deferred Sales Trust as it allows them to defer taxes while waiting for optimal timing. Because the Deferred Sales Trust can be structured to provide regular payments to the investor, it is also a good choice for individuals who need more liquidity and don’t want to wait years to receive their proceeds.
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