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1031 Exchange and the Risks of Investing in a Delaware Statutory Trust

1031 Exchange and the Risks of Investing in a Delaware Statutory Trust

A 1031 exchange provides investors an opportunity to defer tax consequences that come from the sale of an investment property, and when executing a valid exchange, rules and procedures must be followed set forth by the Internal Revenue Code. The requirement in focus is the need of like-kind replacement real estate and the use of a Delaware Statutory Trust (DST). A DST allows investors to own a "fractional interest" in high-quality institutional real estate acquired and managed by large professional real estate firms. DST investments are combined to create a diversified portfolio of passively owned income producing property for accredited investors.

DST investments have many positive attributes, although they are not a good fit for all investors. Part of selecting a DST is to ensure risks are understood. No Investment is 100% risk free, and DSTs are not an exception. Properly understanding the investment process can create a situation that provides an investor with positive cash flow, relief of property management, and a successful investment experience. While the below points capture some risks that need to be discussed they are not limited to these topics. There are some operational restrictions, to help mitigate risk, on how a DST can operate which are noted as, "Seven Deadly Sins", below.

Risks (Sponsor, Real Estate, Control, Fees)

Sponsor
A sponsor is a person or entity that creates a DST to hold real property and arrange for the issuing of beneficial interest to investors. The sponsor typically manages the property on behalf of the investor group during the investment hold period and sells the property at the end of the period. Sponsors that focus on DST investments will create the DST legal entity that will own the property, become the "Master Tenant" of the property (sub-leasing to the actual physical property tenants), and act as the DST signatory trustee.

Who is the sponsor and what is their track record can often be one of the more important pieces of information when selecting a DST investment. While the internet is a wonderful resource for information on the sponsors, every offering memorandum includes the sponsors prior performance, providing yet another tool for investors to use in their assessment. Always beware, however, that past performance does not guarantee future results.

Real Estate
DSTs are real estate at its core, and the risk of investing in any real estate applies here. The sponsor company spends a significant amount of time and resources on the due diligence of selecting and acquiring properties. Often there is debt associated with the DST, which means a lending institution has done their due diligence. DSTs are issued through the securities world, which adds additional layers of due diligence and review from third parties. There are a lot of eyes on these assets and the structure but taking the time to understand the property can cause a better experience.

Where is the property located? Why invest in this asset class? How will debt affect my investment? What is the intended cash flow and total return, and how can that be achieved? What is the worst-case scenario? These are questions to ask yourself and receive guidance on from your trusted advisor.

Control
There are many benefits to investing in a DST such as diversification, regular distributions, and no management responsibilities. With a DST, investors can still enjoy the benefits of owning real estate without dealing with the day-to-day landlord activities. Although this may be a plus for some, others do not want to give up their management responsibilities. With a DST, investors do not have operational control or can make management decisions.

Major decisions, like when to sell the asset in the DST are made by the asset manager and sponsor company. An investor needs to weigh the positives and negatives based on their individual situation to decide if it is the right investment.

Fees
With any investment, there is always a cost. A DST has three major phases, acquisition, operations and disposition, each phase will incur its own economics. As real estate investors' operational cost and disposition fees are not out of the ordinary, you may although find some upfront fees, referred to as "load," need explanation. The load in a DST which may include commissions, Broker Dealer allowances, offering & organization cost, financing fees, etc. are all capitalized into the DST/Investor transaction. Engage with a trusted advisor to understand the application of each invested dollar in a DST.

Understanding that there are fees and costs associated with the DST investment, let's not forget the benefits of being able to invest in institutional investment grade, professionally managed real estate that, in most cases, the assets and management for DSTs would not be accessible to individuals.

DST Operational Restrictions (Seven Deadly Sins)

Real property being held under a DST is eligible to use a 1031 exchange, without the recognition of gain or loss, as long as it meets the following seven restrictions.

  1. Once the offering is closed, there can be no future equity contribution to the DST by any co-investors or beneficiaries.
  2. The Trustee of the DST cannot renegotiate the terms of the existing loans, nor can it borrow any new funds.
  3. The Trustee cannot reinvest the proceeds from the sale of its assets.
  4. The Trustee is limited to making capital expenditures with respect to the property to those for (a) normal repair and maintenance, (b) minor nonstructural capital improvements, and (c) those required by law.
  5. Any liquid cash held in the DST between distribution dates can only be invested in short-term debt obligations.
  6. All cash, other than necessary reserves, must be distributed to the investors or beneficiaries on a current basis.
  7. The Trustee cannot enter into new leases or renegotiate the current leases.