What is a DST 1031 exchange? Everything you need to know.
Published July 24, 2024Share this article
Ready to finally exit your real estate but facing a significant tax liability? If you’re a real estate investor seeking tax-efficient ways to exit your rental properties, you’ve likely heard about a DST 1031 exchange.These are incredibly complex financial vehicles that can solve problems for some investors, but don't go in blind. We'll explain everything you need to know about DST 1031 exchanges: what they are, how they work, the benefits and risks of this real estate strategy, and must-know alternatives.
What we’ll cover:
- What is a DST?
- How does a DST 1031 exchange work?
- Benefits
- Risks
- Alternatives
What is a DST?
A Delaware Statutory Trust (DST) is a legal entity that holds and manages investment-grade real estate that can range from a singular investment property to a large portfolio of multiple properties spanning multiple asset classes. Owners in the trust generally receive a percentage share of the cash flow income and appreciation (or depreciation!).There is an entire marketplace of DSTs offered by blue-chip real estate firms. These firms are known as “sponsors” and are responsible for setting up and organizing the trust. You can access these DSTs through licensed broker-dealers and financial advisors. DSTs typically require minimum investments as low as $25,000 but are typically closer to $100,000.How does a DST 1031 exchange work?
A DST 1031 exchange works similarly to a traditional 1031 exchange. You must first sell your property to a buyer and find a qualified intermediary who will properly store your sale proceeds so as not to realize any tax liabilities. Because DST shares are considered a like-kind property under the US tax code, you have the option of using your proceeds to purchase a stake in a DST. If executed properly, this transaction will allow you to defer the taxes you otherwise would have incurred in a traditional sale.Upon completion of the exchange, you'll own equity in the trust which owns the assets. DST investments tend to last 5 to 10 years. When a DST gets sold, you can either cash out and trigger your tax liability or continue to defer your capital gains tax by executing another 1031 exchange for a traditional property or another DST.Benefits
Here are a few reasons why you might consider a DST 1031 exchange.1. Defer capital gains tax Selling a property can lead to expensive capital gains taxes, even if you plan to reinvest the money elsewhere. A DST 1031 exchange helps you continue growing your investments without facing costly penalties. Keep in mind that cashing out when the DST gets sold is a taxable event.2. Access high-value and alternative asset classes Ordinarily, you wouldn't be able to afford multimillion-dollar investment properties as a solo real estate investor. However, with a pool of investors in a DST, you can acquire partial ownership in expensive high-value properties such as industrial properties, storage facilities, medical offices, retail locations, assisted living centers, apartment buildings, communities, and more.3. Continue earning without the responsibility For the retiring investor, this is perhaps the biggest difference between exchanging for a DST and exchanging for another traditional rental property. The assets in a DST are professionally managed so you won’t have to worry about the day-to-day operations of your investment. Meanwhile, the profits from assets are passed onto you as cash flow. Any appreciation or depreciation of the DST’s assets is realized at the conclusion of the DST.4. Don't worry about loans You won't have to worry about qualifying for any loans to enter a DST. The DST will be responsible for coordinating and qualifying for any loans required for the assets within the fund.Risks
Despite the benefits, it's not all sunshine and rainbows. Make sure you fully understand the following costs and shortcomings of owning a DST.1. Potentially high (and complicated) fees The DST sponsor may charge you a pretty penny for all the work required to set up the DST. Fee structures can include multiple upfront and high ongoing fees. These are often disclosed up front, but the full details can be buried pages deep in the Private Placement Memorandum (PPM), the official DST securities disclosure document.2. Limited liquidity DSTs are considered illiquid assets. You won't be able to access your equity for the duration of the investment, even if the DST underperforms. Typical DSTs span 5-10 years.3. Different asset classes If you’ve built your wealth from residential real estate, DSTs may contain a mix of assets with different risk-and-return profiles from what you’re used to. DST assets can span large multifamily residential, hospitality, office space, industrial, and retail.4. Only a temporary solution DSTs eventually end, at which point you typically have a choice to make: cash out and incur a tax liability or roll the proceeds into another property or DST via the 1031 exchange. Remember those fees? Expect to be set back every time you enter a new DST. Exchanging back into a traditional rental property can be tedious and only leads you back to square one. If you’re seeking a lasting, tax-advantaged exit strategy, other alternatives may better suit your needs.Alternatives
There is another strategy to consider if you’re a retiring landlord seeking a tax-advantaged exit: the 721 exchange. It provides the same benefits as the DST 1031 exchange and solves all the problems with DSTs and more. The 721 exchange allows you to similarly transition into fully passive ownership of a real estate fund in a tax-advantaged way. However, Flock’s 721 exchange fund offers a much simpler transaction process, lower fees, better access to liquidity, and can be a powerful long-term estate planning tool. For more information on the 721 exchange, read our article here or call our team at (720) 703-9992 for a free consultation.Landlords, retire and minimize taxes.
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