Many people who own or would like to own investment real estate may be familiar with the abbreviation “DST.” It is entirely possible that they could be exposed to two differently described DSTs and wonder if they are one and the same, or is one possibly a variation of the other.
The difference between a Delaware Statutory Trust and a Deferred Sales Trust
To avoid further confusion, the two DSTs are entirely different. The Delaware Statutory Trust, is a form of passive ownership in real estate. The other, the Deferred Sales Trust, is a legal tax strategy designed to allow owners of appreciated assets (including real estate, businesses, or other assets that have increased in value), to sell those assets and defer payment of capital gains taxes.
DSTs for Real Estate Investors
Many people own real estate for investment purposes. Such investments are often treated as “passive investments” for tax purposes, but for owners of individual real property assets, they are anything but passive. Property maintenance, tenant issues, repairs and refurbishments, and tenant turnover are all activities that require active attention and investment.
It is not uncommon for such investors, especially in their retirement years, to feel handcuffed by their properties. They never want to stray too far away in case there is a situation — such as a requested repair or a tenant who is late with their rent — which requires their attention.
Some people, including baby boomers, who hold highly-appreciated real estate assets may be at a stage in their lives when they are seeking more passive investment opportunities. Truly passive (professionally managed) ownership may allow them to concentrate on other opportunities in life that they may have always been passionate about but never had the time to thoroughly enjoy.
It is at this intersection that the tale of the two DSTs appears. Both forms of DST can have appeal to investment property owners who wish to trade in the “tenants, toilets, and trash” in favor of the “clubs, cocktails, and cruises.”
The Delaware Statutory Trust enables a real estate investor to maintain an investment position in real estate without the personal management responsibilities.
The Deferred Sales Trust allows a real estate investor to sell a highly-appreciated property and defer the payment of capital gains taxes. The investor can either reallocate the proceeds of the sale into a more liquid and diversified portfolio of securitized investments from which to draw an income or continue to invest in more real estate or business without having to conform to the rigid rules governing 1031 exchanges.
Both strategies have value, and both have their pros and cons.
Delaware Statutory Trusts Pros & Cons
Passive Investment Benefits
Delaware Statutory Trusts are truly a passive way to own real estate. DST investors may benefit from a professionally managed, potentially institutional quality property. The underlying property could be a 500-unit apartment building, a 100,000 square-foot medical office property, or a shopping center leased to investment-grade tenants. The possibilities are almost endless.
A Delaware Statutory Trust may have up to 100 investors (sometimes more) with each investor owning a beneficial interest in the trust, which, in turn, owns the underlying asset. The real estate sponsor firm, which also serves as the master tenant, simply acquires the property under the DST umbrella and opens up the trust for potential investors to purchase a beneficial interest. An investor may either deposit 1031 exchange proceeds into the Delaware Statutory Trust, or the investor may purchase an interest in the DST directly.
Another benefit for the individual investor is that, even though they may need to replace debt (such as through a 1031 exchange requirement), they are not required to qualify individually for the replacement debt in the Delaware Statutory Trust. The sponsor/master tenant is the one responsible for the debt or mortgage on the property.
The Legality of the Delaware Statutory Trust
In 2004, the IRS blessed Delaware Statutory Trusts with an official Revenue Ruling about how to structure the DST to qualify as replacement property for 1031 exchanges. The Revenue Ruling (Rev. Ruling 2004-86) permits the DST to own 100 percent of the fee-simple interest in the underlying real estate and may allow up to 100 investors — sometimes more — to participate as beneficial owners of the property.
Risks of Delaware Statutory Trust
Delaware Statutory Trusts, like any investment, are not without risks. As with any type of real estate investment, investors may be subject to high vacancy rates and loan defaults. Also, these DSTs are not sole-ownership investments. A Delaware Statutory Trust is a more passive investment, made up of multiple owners, and is ultimately controlled by the master tenant — the sponsor. This means that individual investors are not in control of their investment. If they hope to maximize the investment, they may have to hold the Delaware DST investment for 7 to 10 years or longer.
Also, be aware that a greater number of investors, with a larger number of shares, may or may not protect your investment. Careful scrutiny of the controlling partner/sponsor is always advised. (There are a lot of unscrupulous people in this business.)
For example, if you actually read through many of the prospectuses presented for individual Delaware Statutory Trusts, you may see that some or all of the properties acquired for a particular trust had been acquired from the principal sponsors of the trust themselves. However, the profits they made by buying the properties first, and then selling them to the individual partners of the DST, is not disclosed. An investor has no idea if the properties were acquired at competitive market value, or if the purchase price was inflated to the trust.
Economic Benefit of Delaware Statutory Trusts During the Investment Period
Generally, the sponsor/master tenant will distribute net income to the ‘passive investors’ on a regular basis. The amount of the distribution or the “income rate of return” will vary based on several factors including:
- The level of your
pro ratamortgage debt
- The rate of occupancy of the properties
- The amount of investment in upgrades and repairs
- The sponsor/master tenant’s fees charged for the property management along with trust management fees and participation rate (profit margin expected by the sponsor/master tenant)
You will typically be quoted a range of anticipated income return on investment in terms of the expected quarterly distributions to you. Depending on the factors listed above, your actual return may be better or worse than estimated and may vary from time to time.
Sound reasonable? It could be. Sound expensive? Well, it can be. You see, Delaware Statutory Trusts are like mutual funds, except they invest in real estate as opposed to stocks and bonds.
Distributing the Final Profits from a Delaware Statutory Trust
Before any actual property management fees are expended, there are formation costs as well as marketing and distribution costs. These costs will be recouped by the sponsor/master tenant before any profits are distributed to investors. Regarding marketing and distribution costs, most Delaware Statutory Trusts are offered through Registered Investment Advisors. Marketing expenditures are necessary to get their attention, and then commissions are paid to advisors largely in sync with traditional realtor commissions. Once the Delaware Statutory Trust offering is fully funded, the sponsor/master tenant will also collect fees for both property management and the administration of the DST.
It is common to see ongoing fees of between 6% and 15% of gross income deducted from the amount available for distribution to the individual investors. The sponsor/master tenant will then operate the properties for you until they deem that it is time to sell. At that time, they will recoup their initial start-up fees, including marketing and distribution costs, and distribute the remaining balance to the investors.
An individual investor can make money with a Delaware Statutory Trust. Even after the expenses associated with forming and managing these DSTs, individual investors in many cases stand to earn between 6% and 15% annualized return. They just have to be willing to stay the course and wait for the sponsor/master tenant to decide when the time is right for the entire investment group to sell. Individually, an investor may generate an additional profit upon sale, suffer a loss, or get the original principal back. Note that “breaking even” usually results in a net loss because of depreciation write-offs used during the holding period.
It is important for investors who may be considering the Delaware Statutory Trust strategy to consult with an experienced investment professional and to obtain competent legal and tax advice. Upon thorough evaluation, this structure may be a viable investment alternative for qualified real estate investors, but only your tax adviser and a lawyer can tell you if it’s right for you.
The main point is that there can be some real gems in properly managed and administered Delaware Statutory Trusts, and they certainly have their place within the alternative investment arena. At the same time, it is imperative to properly vet these opportunities with professionals who have the requisite knowledge and experience to advise you on the right opportunities to pursue.
Deferred Sales Trust Pros & Cons
If you are considering the sale of investment real estate, a business, or other highly-appreciated assets, you may face capital gains taxes as a result of the sale. For the investor who does not want to continue holding the investment or remain in the same business, a Deferred Sales Trust should be considered. According to section 453 of the Internal Revenue Code, the Deferred Sales Trust provides investors a solution whereby they can defer capital gains upon the sale of the assets and redirect the sale proceeds into cash or whichever types of investments suit their needs, income requirements, and objectives.
What Is a Deferred Sales Trust?
The Deferred Sales Trust is a legal contract between you and a third-party trust in which you sell real or personal property or a business to the DST in exchange for the Deferred Sales Trust’s contractual promise to pay you a certain amount over a predetermined, future period of time in the form of an installment sale note or promissory note. This note is often referred to as a “self-directed note” because you have control over the terms of the note. The Deferred Sales Trust gives a person the ability to control the amount of exposure to capital gains tax, reinvestment terms, and installment payments made from the trust.
How Does a Deferred Sales Trust Work?
The process begins when a property or business owner transfers an asset to a trust managed by a third-party company. This third party acts as a trustee over the asset, and the owner is the secured creditor of the trust that holds the asset. The trust will sell the asset to the ultimate buyer and manage, collect the sales proceeds, and then distribute the proceeds according to the agreed-upon installment contract that the owner sets up ahead of time with the trust.
The sales proceeds can be held in cash, reinvested, and distributed according to the direction of the owner’s installment contract. There are zero taxes to the trust on the transaction since the trust purchases the property from the owner for the same price for which it is resold.
The tax code does not require payment of any of the capital gains taxes until an investor starts receiving installment payments that include principal. The initial owner is able to control if, when, and how there will be capital gains tax exposure over the installment contract period by adjusting the installment contract.
The installment contract between the owner and the trust company provides flexible options on when and how payments are made. The owner may have other income, may not need the installment payments right away, and could defer income and the resulting capital gains taxes. If an owner wants income but does not want to pay capital gains taxes, he/she can set up the installment contract to pay interest-only payments from the reinvested sales proceeds. According to IRC section 453, this strategy can defer the capital gains tax indefinitely.
Guidelines to Establish Legitimacy of a Deferred Sales Trust
In order for a Deferred Sales Trust to qualify for capital gains tax deferral, it must be considered a bona fide third-party trust with a legitimate third-party trustee.
Independent Trustee: The Deferred Sales Trust must employ a trustee that is truly independent of the owner/beneficiary of the trust. If there is not real trustee independence from the owner, then the IRS considers it to be a sham trust, set up for the sole purpose of creating layers of legal documents to avoid taxation. The independent trustee is responsible for managing the trust according to the laws that govern trusts, the installment contract, and the investor’s risk tolerance and investment objectives.
Asset Transfer: In order for the Deferred Sales Trust to shield the owner from capital gains taxes, the owner must not take constructive receipt of any sale proceeds from the disposition of an asset. The trust, which is created on behalf of the investor, must take legal title to sale proceeds directly from the disposition of an asset, or from a third-party qualified intermediary that is holding the sale proceeds on behalf of the investor, in order to qualify for capital gains tax deferral.
Asset Ownership: Ownership of the asset must be legitimately transferred to the trust prior to a sale for the sale proceeds to be sheltered from capital gains tax. If the owner did not transfer practical ownership over to the trust and still retains all of the benefits of direct ownership, the IRS disallows the owner from enjoying the tax-advantaged benefits afforded by the trust’s ownership. In other words, the property must be legitimately transferred to the trust or it will be taxed as if it were not.
Assets Must Remain in Estate: The owner cannot use the trust to transfer any economic interest to a third party without due compensation. The IRS does not allow this type of transaction because it allows people to pass assets out of their estate without bearing capital gains, gift, income, or estate taxes.
The Deferred Sales Trust as a Rescue for a Failed Exchange
One of the most unique benefits of the Deferred Sales Trust is its ability to rescue an investor from capital gains taxes in the event of failed 1031 or 721 tax exchanges. In the case of a 1031 or 721 transaction, the investor’s sale proceeds from the disposition of an asset go to a qualified intermediary (QI). The QI holds these proceeds on behalf of the investor in order to close on a replacement property to complete the investor’s tax-deferred exchange.
Should the exchange fail, whereby the funds cannot be reinvested into a property according to IRS guidelines, the funds held at the QI are subject to capital gains and depreciation recapture taxes once released from the QI to the investor.
The Deferred Sales Trust provides a ready solution to this problem by allowing the funds to revert to a trust rather than to the investor. The investor is saved from taking constructive receipt of the funds and bearing the capital gains and depreciation recapture taxes. The investor can tailor his investment contract with the trustee to distribute the funds in a manner that will effectively defer taxes over the installment contract.
Other Considerations of a Deferred Sales Trust
Some types of depreciation recapture may be deferred, but any excess accelerated depreciation over the straight line depreciation method cannot be deferred.
Fees for setting up a Deferred Sales Trust may be higher than those of a 1031 exchange.
Are Deferred Sales Trusts Legal?
If a Deferred Sales Trust is improperly managed, and the IRS chooses to investigate, it is possible that the trust could be designated as a “sham trust.” Then, if the trust is labeled a sham by the IRS, the income from the initial sale is taxed as though the trust did not exist. Therefore, it is imperative that Deferred Sales Trusts are established and operated according to IRS guidelines and trust law. The use of qualified and experienced professionals is highly recommended. Fortunately, Campbell Law, our tax law firm and the architect of the proprietary strategy known as the Deferred Sales Trust has successfully closed hundreds of millions of dollars in DST transactions over the past 21 years and cleared 14 separate audits and a formal review with the IRS without a single adverse finding.
The applicable tax codes mentioned here apply and relate to federal law only. In addition, individual states may have their own applicable tax codes. Please contact the appropriate tax and legal professional in your state. The information provided here is from sources believed to be reliable, but it should be used in conjunction with professional advice that is consistent with your personal situation.
The three most popular question searches about Deferred Sales Trusts are already mentioned in the article above:
- What is a Deferred Sales Trust?
- How Does a Deferred Sales Trust Work?
- Are Deferred Sales Trusts Legal?