DSTs: Innovative Real Estate Investment Opportunities for Certain Advisory Clients
At a time when investors increasingly seek opportunities outside the traditional stock market, the real estate industry offers many potentially appealing options. Delaware Statutory Trusts, or DSTs, are among the most notable solutions that financial advisors should keep in mind for their clients. They can allow an investor to own a fraction of a larger property and defer taxes.
A DST works like a living or family trust, where a trustee manages the trust for the trust’s beneficiaries. The main differences with a DST are that the trustee should have (and usually has) real estate experience, and that the holdings consist of real property like apartment complexes, senior housing, student residences and self-storage buildings.
Someone who invests in a DST becomes a beneficial owner of that trust. This status qualifies the investor for a 1031 exchange, allowing them to write off expenses on their IRS Schedule E form, continue to depreciate if the investor has remaining depreciation to do so, as well as receive monthly cash flow from rents paid, along with any appreciation, when the property sells.
Different From a TIC
Advisors who are first learning about DSTs might get the impression they’re like a tenancy-in-common, or TIC, which played a part in the housing crisis, market crash and recession we saw between 2007 and 2009. But there are vast differences between the two.
A TIC provides its investors with the power to make investment decisions. For example, decisions to restructure a loan or change a property manager or asset manager would require unanimous consent from the investors. A DST, meanwhile, can’t be refinanced and the decision-making power is held by the trustee, who should have that real estate experience and knowledge.
Additionally, unlike DSTs, TICs can entail lease renegotiations and capital calls. Another important distinction is that stabilized assets are required for a DST but not a TIC. So, a DST is the more conservative structure, better able to prevent scenarios like we saw 15 years ago.
Which Clients Would a DST Fit Best?
There are generally two types of real estate investors to consider here: 1) someone who is young and eager to jump into an investment opportunity where they have significant control, and 2) an older person who wants to cut back on the amount of work in their life. A DST would best fit the second type, who seeks to enjoy what they’ve built over time, earn some income and lessen or defer their tax bill.
As investors in the real estate sector get older, they’ve often been deferring tax payments for many years. As a result, paying the tax on their property investment typically isn’t a good option because it might wipe out half their equity and put a significant dent in their net worth.
The alternative is to “swap until they drop,” meaning to continually conduct 1031 exchanges and defer taxes indefinitely. If the investor continues to do this until they pass away, the deferred tax liability is not transferred to the heirs of the real estate.
Additional estate planning benefits come in the form of a step up in cost basis equal to fair market value at the time the investor passes away. So, the beneficiaries do not inherit depreciation recapture or capital gains tax liabilities on the investment.
A DST is hands-off and can remove the closing risk of a 1031 exchange because the DST owns the real estate. That closing risk is based on the 45-day period for a seller to identify a desired exchange property, as well as the 180-day window from the date of their property sale to complete the exchange. Investors in DSTs enjoy the ability to purchase a piece of real estate they often wouldn’t be able to buy on their own, and can diversify while receiving cash flow.
It’s essential to note that investing in DSTs still comes with potential risks, like relying on the sponsor for continued management or economic volatility that can lead to cash flow suspensions. While accepting these risks may not be for everyone, DSTs can still be a method for meeting the goals of investors looking to enjoy the benefits of real estate ownership without dealing with the management responsibilities.
Conducting Due Diligence
A DST starts with a negative equity position due to its upfront expenses, so when performing due diligence, the most important question to ask is: “Can the real estate inside the DST overcome those expenses?” The key follow-up question is, “If so, when?”
My firm’s primary goals for our clients are to protect their principal and provide them with stable income, in that order. The third goal would be for a property to offer appreciation beyond that principal when it sells. We do as much due diligence as possible based on the data provided for each real estate portfolio.
Nobody can control the economy, but we aim to assess how desirable a transaction would be by focusing on net operating income and estimating the point in time when a piece of real estate would overcome the upfront DST expenses.
Talking With a Sponsor
Many professionals are involved in the DST process, from financial advisors to attorneys, CPAs and qualified intermediaries. My company typically interacts with two types of financial professionals: 1) independent broker-dealer advisors whose firm may not have an approved product for them to offer, and 2) registered investment advisors seeking to refer clients interested in tax deferrals to a company that focuses on DSTs.
As DSTs gain wider recognition, I’m starting to see many advisors enter the space and focus strongly on the DST sponsor for a given property, looking at how many decades that company has been in business. But it’s important to remember that the actual real estate is what drives returns, so I recommend that advisors begin with focusing on that aspect.
If the real estate works, then you can start focusing more on tenure and the people who control that property. Otherwise, you might end up wasting valuable time on real estate that doesn’t deserve it.
Edward Fernandez is President and CEO of 1031 Crowdfunding, a real estate investment platform for 1031 exchanges and alternative investment vehicles focused on tax deferral