The use of Delaware Statutory Trusts (DSTs) in a 1031 Exchange are steadily growing in popularity. Last year alone, this space increased by 30% with almost $2 billion flowing into DSTs from over 25 plan sponsors. A DST has been a valuable tool for the last 14 years since the IRS issued Revenue Ruling 2004-86.
A DST is a separate legal entity formed as a trust under Delaware law. An investor can use a beneficial interest in a DST as replacement property in a 1031 tax deferred exchange. A DST is structured where each investor owns a beneficial interest in the trust. The managing trustee of the DST is the sponsor. The DST must distribute all income, other than the necessary reserves, to the beneficiaries.
A DST is used in several ways by different types of investors. Passive investors, often baby boomers, are the fastest growing segment of a DST investor. Passive investors use a DST to further diversify their portfolio, relieve themselves of the many headaches of active management and to create a cleaner transition of real estate to their heirs. Active investors pivot to a DST when finding a replacement property becomes troublesome, or when the value of the replacement property is less than the relinquished property. The IRS refers to this “leftover” in a 1031 exchange as the boot. Prudent investors use a DST as insurance by identifying a DST in addition to their preferred property. If the preferred property becomes unattainable due to financing or environmental issues, for example, this back up or parachute option protects the integrity of the 1031 exchange. A DST is also used to ensure the debt to equity ratio in the exchange remains the same or greater.
As competition between sponsors becomes greater, the ingenuity of the DST continues to expand. Earlier this year, one of the leading sponsors unveiled a DST with a “cash out structure”. This unique structure allows the exchanger to defer 100% of the taxes while receiving approximately 70% of the equity portion back in cash.
Step 1: $1 million 1031 equity investment into a DST
Step 2: Approximately 90 days after the closing of the DST, the sponsor finances the property in the DST
Step 3: Approximately $700,000 is returned to the investor, “cash out”
Before the financing is secured and “cash out” is executed the investor receives a monthly 5% cash-on-cash return. Post financing, the investor receives a monthly 4% cash-on-cash return on the remaining 30% equity in the DST. This new structure is a game changer for the 1031 market. We anticipate competing sponsors will unveil DSTs with similar features. These cash out DSTs resolve the exchanger’s 1031 tax liability while relinquishing control, liquidity, and flexibility back to the investor. Most importantly, please coordinate your strategy with your tax adviser, attorney, real estate agent and financial advisor. Stonecrest Partners is a boutique independent financial services enterprise that includes sister companies Stonecrest Capital Markets, Inc. and Stonecrest Advisors, Inc.
*Securities offered through Stonecrest Capital Markets, Inc, Member FINRA/SIPC.