Selling a highly appreciated investment property can create an uncomfortable dilemma: take the proceeds and potentially recognize a substantial capital gain, or complete a 1031 exchange and become responsible for yet another investment property.
For some Arizona property owners, there is a lesser-known third option worth discussing with their tax and financial advisors: a DST, or Delaware Statutory Trust.
What Is a DST?
A Delaware Statutory Trust is a legal trust structure that can own institutional-quality real estate such as apartment communities, medical facilities, industrial properties, self-storage facilities or other commercial assets. Individual investors purchase beneficial interests in the trust rather than directly managing the underlying properties.
The important connection to real estate sellers is that qualifying DST interests may serve as replacement property in a Section 1031 exchange.
In other words, the DST isn’t really an alternative to a 1031 exchange. It can be an alternative to buying another property yourself when completing a 1031 exchange.
Why Would an Arizona Seller Consider One?
Imagine an owner purchased an Arizona rental property years ago for $500,000 and can now sell it for $2 million. Selling and simply taking the proceeds could create significant federal and potentially state tax consequences.
A traditional 1031 exchange can potentially defer certain taxes by reinvesting the proceeds into qualifying replacement real estate. But that presents another problem: What if the owner is ready to sell precisely because they’re tired of owning and managing real estate?
Finding another rental property, negotiating the purchase, arranging financing, handling tenants and overseeing maintenance may be exactly what the seller is trying to leave behind.
That’s where a DST can become interesting.
Instead of exchanging into another individually owned rental property, an eligible investor may be able to exchange into fractional interests in one or more DST-owned properties. Professional sponsors generally handle the acquisition, financing and property management.
The investor moves from being an active landlord toward a considerably more passive form of real estate ownership.
The 45-Day Problem
DSTs can also address one of the biggest practical challenges associated with a 1031 exchange: time.
Under current federal rules, an exchanger generally has just 45 days after selling the relinquished property to identify potential replacement property and 180 days to complete the exchange, subject to applicable tax-return deadlines.
In a competitive market, 45 days can disappear quickly.
A seller trying to identify a suitable $2 million replacement property may feel pressured into purchasing something simply to preserve the exchange.
DST offerings can potentially provide another avenue for satisfying replacement-property requirements without locating and negotiating the purchase of an entire property.
DSTs Aren’t for Everyone
The convenience comes with important tradeoffs.
DST investments are generally illiquid. Investors surrender much of the control they would have with direct property ownership. Fees, sponsor quality, financing, projected distributions, property type, tenant concentration and the underlying real estate all require careful evaluation.
DST interests are also commonly offered as securities and may only be available to investors meeting applicable eligibility requirements, including accredited-investor standards in many offerings.
A DST should therefore never be selected simply because a 1031 deadline is approaching.
Plan Before the Property Is Listed
For owners of highly appreciated Arizona investment real estate, the best time to investigate a 1031 strategy is usually before the property closes—not after the proceeds arrive.
The structure of the transaction matters, including the use of a qualified intermediary and strict compliance with IRS requirements.
For owners considering the sale of a valuable rental, multifamily property, commercial building or other investment real estate, understanding options such as 1031 exchanges and DSTs before listing can create considerably more flexibility.
The first question isn’t necessarily “What should I buy next?”
It may be:
“Do I even want to own and manage another property?”
For some Arizona sellers, discovering the answer to that question is what makes a DST worth knowing about.
This article is for general informational purposes only and is not tax, legal, investment or securities advice. Property owners should consult qualified tax, legal and financial professionals regarding their individual circumstances.
