Is a Delaware Statutory Trust Right for You?
Delaware Statutory Trusts can provide accredited investors with a different way to participate in investment real estate, including as a potential replacement property strategy for certain 1031 exchanges.
For some investors, the appeal is the opportunity to move away from active property management while maintaining exposure to real estate. But DSTs also involve meaningful tradeoffs, including limited liquidity, reduced investor control, fees, property-level risk, and the possibility of losing invested principal.
Understanding both sides is essential before deciding whether a DST deserves a place in your investment strategy.
What Are the Potential Benefits of a Delaware Statutory Trust?
Reduced Property Management Responsibilities
One of the primary differences between a DST and directly owned real estate is the investor’s role in managing the property.
With a DST, day-to-day property operations are generally handled through the sponsor and property management structure rather than by individual beneficial owners.
For investors who no longer want to personally deal with tenants, leasing, maintenance, capital improvements, property managers, or other landlord responsibilities, this may be an important consideration.
Access to Professionally Managed Real Estate
DST offerings may provide investors with access to professionally managed commercial real estate that they might not purchase individually.
Depending on available offerings, this may include multifamily communities, industrial properties, healthcare facilities, self-storage properties, retail assets, and other types of commercial real estate.
Access to a larger or professionally managed property does not make the investment inherently safer or more profitable. The specific real estate and investment structure still need to be evaluated carefully.
Potential for Real Estate Diversification
Rather than placing all exchange proceeds into a single directly owned property, some investors may be able to allocate capital among multiple DST offerings. Depending on investment amounts and available opportunities, this can create exposure to different:
- Property types
- Geographic markets
- Tenants
- Sponsors
- Financing structures
- Real estate strategies
Diversification can help reduce concentration in a single asset, but it does not eliminate investment risk.
DSTs as Potential 1031 Replacement Property
Certain properly structured DST interests may qualify as replacement property in a Section 1031 exchange.
IRS Revenue Ruling 2004-86 concluded that, under the facts described in the ruling, beneficial owners of the DST were treated as owning fractional interests in the underlying real property for federal income tax purposes. The ruling further concluded that exchanging qualifying real property for an interest in the described DST could qualify under Section 1031 when the other requirements were satisfied.
For qualifying investors, this can provide another replacement property strategy to evaluate alongside directly owned real estate.
It is important not to assume that every DST automatically qualifies. The structure of the offering and the individual exchange must satisfy applicable requirements.
Potentially Smaller Investment Amounts Than Direct Ownership
Purchasing an entire commercial property directly can require a substantial amount of capital.
Because DST investors purchase beneficial interests rather than the entire property, some offerings may allow participation at investment amounts below what would be required to acquire a comparable property individually.
This can also provide flexibility for investors who want to divide exchange proceeds among multiple potential investments rather than concentrating all of their equity into one asset.
Minimum investment requirements vary by offering.
Financing May Already Be in Place
Some DST properties are acquired with financing already established at the trust level.
For an investor completing a 1031 exchange, this can be relevant when evaluating the debt associated with the relinquished property and the replacement property strategy.
DST financing structures vary significantly. Some offerings use leverage, while others may have little or no property-level debt.
Existing financing can simplify certain aspects of acquiring an interest, but leverage also introduces additional financial risk and should be evaluated carefully.
What Are the Risks of Investing in a DST?
The characteristics that make DSTs appealing to some investors also create important limitations.
DST interests are investments in real estate and, commonly, private securities offerings. Investors should be prepared for the possibility of declining property values, reduced or suspended distributions, limited liquidity, and loss of principal. The current Customized 1031 disclosures expressly identify these types of risks.
01
Limited Liquidity
DST interests are generally not publicly traded on an established securities market. IRS Revenue Ruling 2004-86 itself describes the interests in the DST considered by the ruling as not publicly traded on an established securities market.
Investors should not assume they will be able to sell a DST interest whenever they choose.
Many private placement investments can be difficult to sell, and FINRA identifies illiquidity as a material risk that firms should clearly disclose when discussing private placements.
A DST may therefore be inappropriate for money an investor expects to need in the near future.
02
Limited Investor Control
A directly owned property gives the owner significant authority over decisions such as leasing, refinancing, improvements, property management, and disposition.
DST investors generally do not have that same decision-making authority.
The structure is intentionally restrictive. Revenue Ruling 2004-86 explains that the trustee in the qualifying structure has limited powers and cannot freely vary the investments held by the trust.
For an investor accustomed to controlling every aspect of a property, that can be a significant adjustment.
03
Real Estate Market and Property Risk
The value and performance of the underlying property can be affected by factors such as:
- Vacancy
- Tenant defaults
- Changes in rental rates
- Property expenses
- Repairs and capital requirements
- Local economic conditions
- Interest rates
- Competition
- Changes in property values
- Natural disasters or property damage
A professionally managed property can still decline in value or generate less income than anticipated.
04
Distributions Are Not Guaranteed
Those distributions can change.
Vacancy, tenant problems, unexpected expenses, financing costs, property damage, or other factors may reduce or eliminate available cash flow.
Customized 1031's current disclosures specifically note the potential for cash flow distributions to be reduced or suspended when real estate experiences adverse events.
Projected distributions should therefore be viewed as assumptions rather than guarantees.
05
Sponsor and Management Risk
That makes sponsor evaluation an important part of due diligence.
Investors may want to consider factors including:
- Sponsor experience
- History with similar property types
- Acquisition discipline
- Financing approach
- Property management experience
- Fee structure
- Conflicts of interest
- Assumptions used in projections
- Planned exit strategy
The quality of the real estate does not eliminate the importance of the sponsor responsible for structuring and managing the investment.
06
Fees and Expenses
Depending on the offering, these may relate to acquisition, financing, brokerage, property management, asset management, disposition, and other services.
Those costs can affect overall investment performance.
Customized 1031's existing disclosures appropriately note that transaction costs and expenses can affect investor returns and may outweigh anticipated tax benefits in some circumstances.
Investors should review the offering documents carefully to understand how fees are structured and who receives them.
07
Financing and Leverage Risk
If a DST property has debt, changing interest rates, property performance, refinancing conditions, or a decline in value may affect the investment.
Financed real estate also carries the potential for foreclosure if obligations cannot be met. This is another risk identified in Customized 1031's existing disclosures.
Investors should understand both the amount of leverage and the terms of the financing associated with a particular offering.
08
Private Placement Considerations
Private placements can differ materially from publicly traded securities. FINRA notes that many private placements may have limited liquidity and less comprehensive information available for valuation than investments traded in transparent public markets.
Investors should review the applicable Private Placement Memorandum and other offering materials before making an investment decision.
The fact that an investor qualifies to participate in a private offering does not mean the investment is appropriate for that investor.
09
Tax Treatment Is Not Guaranteed
Section 1031 treatment depends on satisfying applicable requirements, and the tax consequences of an exchange depend on the investor's individual circumstances.
Revenue Ruling 2004-86 applies to the specific DST structure addressed in the ruling and states that Section 1031 treatment applies when the other requirements of Section 1031 are also satisfied.
Investors should work with their own CPA or qualified tax professional regarding the tax consequences of an exchange and DST investment.
How Should You Evaluate the Benefits and Risks of a DST?
The question should not simply be whether DSTs are “good” or “bad.” The more useful question is whether the characteristics of a specific DST align with your investment objectives and circumstances.
Consider:
Your Management Preferences
Are you trying to step away from active property ownership, or is maintaining control important to you?
Your Liquidity Needs
Can you commit capital to an investment that may be difficult to sell before the property is eventually disposed of?
Your Risk Tolerance
Are you comfortable with the property, sponsor, leverage, market, and private investment risks involved?
Your Real Estate Exposure
Would the investment increase concentration, or could it provide useful diversification within your broader portfolio?
Your Investment Horizon
Does the anticipated investment period align with your financial plans?
The Specific Offering
Most importantly, does the actual DST opportunity make sense after reviewing the property, sponsor, financing, fees, assumptions, risks, and offering documents?
A DST Is a Real Estate Investment, Not Just a 1031 Solution
The ability to potentially use a DST as replacement property can make the structure particularly relevant to investors completing 1031 exchanges.
But satisfying an exchange need should not replace investment due diligence.
A DST should be evaluated first as an investment in real estate, including the quality of the property, structure of the offering, sponsor, financing, costs, expected holding period, and material risks.
If those factors do not make sense for the investor, the potential tax treatment alone should not make the investment compelling.
Understand Your Options Before Investing
Delaware Statutory Trusts can offer a different approach to real estate ownership, but the tradeoffs need to be understood.
If you are considering a DST as part of a 1031 exchange or broader real estate investment strategy, Doug Zator can help you evaluate available opportunities in the context of your goals and circumstances.