The Delaware Statutory Trust (DST) is gaining popularity as a viable solution for accredited real estate investors seeking replacement property for their 1031 exchanges. For those unfamiliar, a Delaware Statutory Trust is a legal trust structure under Delaware law recognized under Revenue Ruling 2004-86 that offers accredited investors fractional ownership of beneficial interests to satisfy their 1031 exchange needs.
A DST comes to accredited investors as a package program that offers them potential annual income, credit for any nonrecourse debt associated with the DST, the potential for appreciation or equity growth all while being managed by major real estate institutions within the United States. As the commercial real estate market continues to appreciate, real estate investors want to take advantage of their highly appreciated asset(s) but struggle to find replacement property.
This story is not just for the “mom-and-pop” real estate owners!
It is the same families that have owned assets through multi-generations whose properties have turned in to multimillion-dollar opportunities. The families recognize the chance for them to “cash in” on such tremendous gains by selling their current property but that can all easily be erased by not planning properly to execute a successful 1031 exchange.
We have come across many instances where “mom-and-pop ” have owned a highly appreciated property and the “son and daughter” know it is the right time to sell but do not have a suitable replacement option lined up nor have the wherewithal to manage a new replacement property whilst “mom-and-pop” seek to enjoy retiring from managing their building(s).
One of the latest transactions we handled was a complex case involving three arms of a family that shared ownership in an assemblage of real estate through an S Corporation.
The S Corp was originally formed in the early 1900s by three brothers and it held an assemblage of Manhattan based real estate worth approximately $31,000,000. One of the many criteria in executing a successful 1031 exchange is the replacement property must be purchased by the same owner (aka same taxpayer ). Since this real estate was owned through an S Corp it eliminated the opportunity to do what is known as a “Drop and Swap.”
A “Drop and Swap,” often done in LLCs & partnerships, would have allowed the entity to be broken up in to three different arms allowing each “investor” to do as they wish with their portion of the proceeds from the sale. Beyond not being able to conduct a “Drop and Swap,” one arm of the family had a step up in cost basis due to the passing of one of the original brothers, another arm was seeking to purchase direct real estate to manage, and the third arm was seeking a more passive solution; all while waiting for the appropriate time the S Corp would be able to divest with minimal taxable consequences.
Considering all the information above, the DST posed as the most viable solution for this case.
Utilizing the DST, we were able to customize a blend of suitable investments for each arm of the family satisfying all the needs of a 1031 exchange as well as their needs for a future divestiture from the original entity. The DST offered many potential benefits that played a major role in the decision making on the direction of this transaction.
During the identification period (45 calendar days from the sale of the relinquished property) we explored many different potential solutions. One included a portion of the proceeds being allocated toward direct property to be managed by one arm of the family, so they could own assets under their control outside of the other members seeking a more passive solution. This also posed a problem when trying to stay within the guidelines of the 200% rule for identification purposes because the direct real estate could not effectively and safely be backed up should there be any shortcomings on that side of the transaction.
The major consideration the family was faced with was that the property was owned for so long there was almost no cost basis. There was also no debt associated with it at the time of the sale, so the S Corp was looking at a potential $31,000,000 taxable gain. Don’t forget, since this was owned in an S Corp everything would be taxed at the entity level and passed through to each shareholder should something go awry during their exchange period.
Utilizing a portfolio of DSTs , we were able to implement real estate portfolio that spanned across several states and sectors of real estate through more than 10 different DSTs and over five different sponsors for a total purchase of approximately $61,000,000 of real estate.
With the DST being a security, it offered the comfort of knowing the investors were guaranteed to close on the investments they identified. At the same time, the DST offers operational flexibility and can easily be broken up in to smaller tranches specific to each arm of the family in the future. This eliminates the concern of one property appreciating more than the other since all the arms are invested in the same exact building(s) within the DSTs.
Next, by incorporating levered DSTs the S Corp had the potential to increase their cost basis from their original investment which would afford them the opportunity to depreciate their new basis and create potential tax efficient income that was generated by the portfolio.
Finally, the family was able to eliminate the burden of the dreaded three T’s: toilets, tenants, and trash. Rolling their proceeds in to the portfolio of DSTs put the investors side by side with multibillion institutions alleviating their day-to-day decision making and management responsibilities. When the remaining original shareholders have passed, the other families would receive their step up in cost basis and the S Corp will be broken up with minimal taxable consequences.
The DSTs would then be able to be split on a pro rata basis to each shareholder for them to receive their respective proceeds when the DST goes full cycle.
A Delaware Statutory Trust solution is not for every investor but those faced with difficult decision making, multiple parties, and many moving parts have found the passive nature offered by a DST to be a comfortable solution. This was one of the more complex cases as it involved more than 20 different investors all involved in one entity with their own wants and needs.