DST vs Direct Property in a 1031 Exchange: Benefits, Risks and How to Choose

Choosing between a DST vs direct property in a 1031 exchange is one of the most consequential decisions a property investor can make, and the right answer depends entirely where you are in your investing journey.

This guide walks through the pros and cons of Delaware Statutory Trusts (DSTs) as 1031 replacement properties, particularly for retirees and investors looking to transition to passive real estate investing.

For more than a century, property owners have been able to defer capital gains taxes on the sale of business or investment property through IRC Section 1031 like-kind exchanges. 1031 exchanges rely on the acquisition of “like-kind“ replacement property, using a broad definition of that term. Traditionally, this has meant the exchange of individual properties held through a variety of ownership structures.

In 2004, the IRS issued Revenue Ruling 2004-86, allowing for beneficial interests in Delaware Statutory Trusts (DSTs) be treated as like-kind replacement properties under Section 1031. This means fractional interests in DSTs can function as like-kind properties in 1031 exchanges, allowing exchangers to go from directly-owned property to DST interests and vice-versa while continuing capital gains tax deferral.

For 1031 investors who only have experience with direct property ownership, the benefits of a DST might not be obvious, but for some exchangers, choosing a DST as a replacement property is the right move. Understanding the pros and cons of DSTs vs traditional 1031 replacement properties can help you make a more informed decision.

DST benefits: simplicity, diversification and passive income

Delaware Statutory Trusts, in which investors pool their capital to invest in property overseen by a professional property manager, have several advantages as 1031 replacement properties, with the most obvious being portfolio diversification.

Portfolio diversification

DSTs come in two forms: single-asset DSTs, which own one large commercial property, and multi-asset DSTs, which hold a portfolio of properties. A multi-property DST provides instant diversification for investors, as well as access to new markets and institutional-quality commercial real estate they may not otherwise have access to. What’s more, the cost of entry can be lower: many DSTs have low minimum investment amounts, meaning the proceeds from a single property sale can be exchanged into multiple DSTs. Going from a single property of one type in one market to a series of DSTs, each targeting different property types and markets, can mean a big leap in real estate portfolio diversification.

This diversification can be helpful in maintaining overall value in uncertain times. While a lone property can increase or decrease in value depending on the market, DSTs are seen as an inflation hedge because they invest in sectors that have historically thrived in down economies.

Passive income for retirees

The second major advantage is passive income. DST investors receive distributions from the rent paid on the DST’s properties, but they don’t have to concern themselves with duties like collecting rent, maintenance, or other tasks that are instead performed by a professional property manager and the DST sponsor. For investors who have spent years as active landlords, this shift to passive real estate investing can be a significant quality-of-life improvement.

These regular distributions can make DSTs an attractive option for retirees. By transitioning from active to passive property management, they can supply themselves with steady income for retirement. And by diversifying with multiple DSTs, estate planning be simplified: instead of leaving behind a single property to a group of heirs, DST interests can be divided up among inheritors while still receiving a step up in basis.

Non-recourse debt and transaction reliability

DSTs also have a reputation for reliability. DST debt is non-recourse, meaning it is taken on by the DST, not its investors, lowering the risk for the individual. The properties have already been vetted by the DST sponsor, and aren’t in danger of falling through in a competitive real estate market, meaning transactions can be closed quickly and have a greater chance of success. Many exchangers use DSTs as a backup option among their identified properties in case a desired replacement property falls through.

Whether you’re looking at a DST as a backup or primary option, these are just a few of the reasons investors choose DSTs as like-kind replacement properties in a 1031 exchange. However, there are some downsides, and certain investors may find the advantages of direct property ownership outweigh the diversification and passivity of a DST.

Direct property benefits: liquidity, control and exit strategy flexibility

Control and management flexibility

With direct property ownership, you control the decision-making, so you can purchase the exact property you want. With a DST, the portfolio properties have already been selected. If there are three properties in the DST and you only like two of them, you can’t choose to invest solely in the two you like – it’s all or nothing.

The control of direct property ownership also means you can choose the tenant, rent terms, and how management duties are performed (because they’ll be performed by you). Actively managing a property requires work, but for some investors, this can be a good thing, especially when it comes time to sell.

Liquidity and exit strategy options

The biggest structural difference between DSTs and direct ownership is liquidity and exit flexibility including DST liquidity. Directly-owned property can be sold when market conditions are favourable, allowing you to time the market and maximise returns. DSTs have a fixed holding period, and the assets are not sold until that period ends, regardless of market conditions. The only way to exit a DST early is to find a buyer for your DST interest on the secondary market — which is not guaranteed. If no buyer is found, you are locked in for the full holding period.

That said, when the holding period ends, the DST sponsor may provide a new DST that you can exchange into, making subsequent 1031 exchanges simpler. This is a plus for those who want simplicity, but for those who crave control, it may not be much of a benefit.

Advanced Options: 721 UPREIT Exchange

There is also the possibility of a 721 UPREIT exchange, in which an exchanger can go from a DST to a Real Estate Investment Trust (REIT), further increasing their diversification. This option isn’t for everyone, but it should be noted that for investors who want to defer taxes and move from a directly-owned property to REIT shares, there is a way to do so.

It’s also important to note that DSTs fees are charged in order to pay property managers, and if you fail to understand those fees, your returns may be lower than you expect. What you’re paying for is diversification, institutional-quality real estate, and passive income while sacrificing control and flexibility. If that seems like an easy choice, then you already know which one you want to pursue.

Triple-net (NNN) lease and other passive alternatives

If you’re still unsure, there are other options like triple-net (NNN) leases that are more passive than traditional property, but allow for greater control than DSTs. No matter what you choose, it’s important to make sure you take full advantage of the tax deferral allowed by Section 1031.

How JTC can help with DST and direct property 1031 exchanges

Whether you exchange into a DST or a directly-owned property, every 1031 exchange requires a Qualified Intermediary (QI) to hold exchange proceeds and ensure IRS compliance. For exchanges involving multiple DSTs, calculating the correct debt ratio and investment amounts to achieve full tax deferral is particularly complex — and requires a QI with specific experience in DST exchanges.

JTC’s 1031 exchange team has decades of experience in 1031, with specific expertise in the most complicated types of exchanges, including those involving Delaware Statutory Trusts. That’s why JTC is the QI of choice for many DST sponsors. We provide full transparency and security measures to help our clients ensure that even when they’re exchanging into a new property type, they receive the same institutional-quality technology and support they need for 1031 exchange success.

Learn about JTC’s 1031 exchange services