Why a Delaware Statutory Trust Can Be One of the Most Reliable 1031 Replacement Properties in a Tight Market

At a JTC event, industry veterans explained the unique qualities of a Delaware Statutory Trust (DST) and why DSTs are among the most reliable replacement property options for achieving full tax 1031 deferral in today’s market.

As we explained in a recent piece on the 1031 exchange market, there was a time when 1031 exchange investors were a bit spoiled. Interest rates were low, making it easier to find deals that penciled out, and an active market meant finding replacement properties for a 1031 exchange was much simpler than it is today.

Now, things are a lot different. Interest rates remain higher than they once were, and transaction volume has declined over the past few years. It’s no longer a given that an exchanger will be able to find an adequate 1031 replacement property within the strict 1031 time frame. How can taxpayers mitigate the risk of executing an exchange in an environment where there is so little margin for error?

As times change, strategies need to be adjusted to meet the current market. To help property owners understand the options available to them, JTC gathered a panel of industry experts to explain some lesser-known techniques that can make exchanges easier to manage in a higher-for-longer rate environment. One of the techniques discussed – and perhaps the simplest for everyday property owners to take advantage of – was the use of Delaware Statutory Trusts as replacement properties.

How a 1031 exchange works with a Delaware Statutory Trust

At the event, Navigating a 1031 Exchange in Today’s Real Estate Market, the panelists explained that while like-kind exchanges have existed for over 100 years, there have been major changes to Section 1031 in the last decade.

“You used to be able to do like-kind exchanges with personal property. It wasn’t just real estate. But they eliminated that, so you have to exchange real property for real property,” said Nick Scarfone of Barclay Damon LLP. “You also cannot exchange real estate for an intangible asset, like a partnership interest.”

While this limits 1031 exchanges to real property, the parameters aren’t as restrictive as you may think. Because of the rather loose definition of “like kind” as it relates to 1031, it’s possible to exchange properties with quite different qualities, such as going from an industrial property to a residential property or vice versa. You can even, as JTC Senior Manager – Client Services Nicole Vella noted, perform an exchange with multiple properties.

“You can do one for one, one for many, or many for one,” said Vella, who explained that this makes 1031 like-kind exchanges useful for those who want to consolidate their investments into a single high-value property as well as those who want to diversify across a series of properties. It’s also possible to perform an exchange with only part of a property if that part is used for business or investment purposes.

“People have converted certain parts of their homes for their occupation or business,” as well as exchanging owner-occupied units, said JTC National Sales Manager and Account Executive Justin Amos.

Things get a bit more complicated when a single property is owned by multiple people. Because of the same taxpayer rule, it isn’t possible to exchange an interest in a partnership or multi-member LLC. However, there are ways to exit a partnership and perform an exchange, if you have the right knowledge and help. For example, the PIN method can allow for one member to exit an LLC. And by converting to a tenancy-in-common (TIC), the drop and swap method allows for a change in membership along with an exchange.

As Scarfone explained, even though a TIC may appear much different from a whole property, it is considered like-kind real property for 1031 exchange purposes.

“The IRS will respect that TIC interest as real estate for 1031 purposes, if you comply with certain requirements,” he said.

The same is true of an interest in a Delaware Statutory Trust (DST), which involves fractional ownership of a portfolio of properties – a form of fractional real estate investment – that are managed by a professional property manager. DST investors work with a DST sponsor that oversees the portfolio, but it’s the underlying properties in the portfolio that make the DST interest eligible under Section 1031.

“You may not consider a Delaware Statutory Trust as a property, but it is, because it’s a portfolio of properties that are the underlying investment,” said Vella.

“All of the beneficiaries of the trust are considered to own their pro rata share of the real estate owned by the trust,” said Scarfone.

Benefits of Delaware Statutory Trusts as 1031 replacement properties

Because DSTs are so different from whole properties, they have their own advantages when it comes to using them as 1031 DST replacement properties. For starters, they have a lower bar for entry than whole properties. It’s possible to exchange into a DST for as little as $100,000, meaning you can invest in several DSTs for the same amount that a single rental property might cost. In addition, the debt is non-recourse, protecting individual investors in the event of major economic changes.

A key advantage of DSTs is instant diversification. There are single-property DSTs and multi-property DSTs, and by spreading your sales proceeds across sectors and regions, you can diversify in a way that simply isn’t possible with directly-owned properties. This makes the Delaware Statutory Trust 1031 exchange route particularly compelling for investors exiting a large, concentrated asset.

As Vella explained, “a lot of people might just own, say, one large property, and they want to slim down” by spreading their investment across “multiple smaller properties, and throw in a DST there, because they want more passive income. Rather than putting all the risk into one property, they’re looking to spread that out.”

This passive real estate investment is another major benefit of DSTs. Because the properties are pre-vetted and overseen by a professional property manager, a lot of the legwork has already been done, making it an attractive passive real estate investment. DSTs and triple-net lease (NNN) properties are extremely popular among retirees who no longer wish to perform management duties.

“They’d rather do the passive income or the triple-net leases, so that they don’t have to worry about the day-to-day operations of owning the property,” said Vella.

DSTs are great for “taxpayers who need to acquire real estate to complete an exchange that satisfies the bill, and they don’t want to deal necessarily with the management of the property,” said Scarfone. “So in a Delaware Statutory Trust, the trustee handles that.”

Summary of key DST benefits as a 1031 replacement property:

DSTs as a Reliable 1031 Tax Deferral Strategy in High-Rate Environments

The number-one advantage of a DST replacement property in a tough market is its reliability. While other deals might fall through, the DST’s portfolio is set. That’s why a DST replacement property makes an ideal backup when identifying 1031 exchange replacement property options. You can find a DST with a particular debt ratio to meet your needs, “a solution that can absorb both the debt and equity,” as Amos explained.

Having a DST also allows exchangers to look at a wider range of potential properties. Under normal circumstances, if your replacement property is of lower value than your relinquished property, you will end up with taxable boot. But if you add a DST to the equation as an additional 1031 exchange replacement property, you could achieve full 1031 tax deferral by acquiring the chosen property along with a DST.

“To do the full deferral, you do need to meet or exceed the value that you sold the relinquished property for,” explained Vella. Knowing that you don’t have to find a single property that meets this need can allow you to look at lower-value properties that otherwise might produce boot and combine them with a DST to achieve complete 1031 tax deferral.

DSTs also work well in higher-for-longer rate environments where exchangers are thinking of holding properties for longer. As Amos said at the webinar, “today’s focus is a lot more on stable cash flow, long-term fundamental investments, rather than short-term appreciation. So, when people are looking to buy, it’s with an understanding that they’re going to be holding this property for a longer period of time.”

A DST has a set holding period, and at the end of that period, investors can choose to exchange into another DST or into directly-owned property, depending on the environment at that time. Receiving steady income while waiting out tough conditions is a key appeal of this passive real estate investment structure.

“Higher interest rate environments, people are starting to look into more passive options,” said Amos.

DSTs are not right for everyone, but the big mistake would be thinking that it isn’t possible to perform an exchange now just because good 1031 exchange replacement properties are tough to find.

“Overall, is it a good time to do a 1031 exchange?” said Amos. “It really depends on your goals.”

Check out the full webinar for more discussion of DSTs, advanced 1031 techniques like reverse exchanges and improvement exchanges, and some of the most common questions JTC’s 1031 experts receive.

Watch the full webinar

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