Tags: DST 1031 Exchange

If you’ve been thinking about engaging in a 1031 exchange, a Delaware Statutory Trust (DST) can be an excellent option. However, before getting involved, it’s important to understand the ins and outs of how they work. In particular, there are “7 Deadly Sins” that must be avoided. Otherwise, the DST will fail to meet the “like-kind” requirements established by the IRS.

Sometimes, even if the trustee has the best of intentions, an error can cause the DST to lose its qualification as a “suitable investment” for the purpose of a tax-deferred 1031 exchange. This can have devastating tax implications, resulting in heavy losses. Here’s an overview of the seven critical mistakes trustees musts avoid.

1. Future Equity Contributions

An investment in a DST gives the purchaser a certain percentage of ownership. After the DST is closed, any additional contributions by current or new investors would dilute the original ownership percentage. For this reason, the IRS does not allow trustees to accept any additional equity contributions from new or existing investors after the DST is closed.

2. New Borrowing or Renegotiating Terms

Before purchasing a DST as part of a 1031 exchange, investors need to complete a thorough evaluation to determine whether they believe it’s a smart investment. Examining the liabilities of the DST is part of this due diligence.

If a trustee were to take on additional loans or modify the terms of the current loans, this would change the risk of the investment. Since DST beneficiaries don’t have voting rights when it comes to operating decisions, this rule protects them from actions that could significantly impact the investment's risk profile after they've made their purchase. 

3. Reinvestment of Sale Proceeds

The IRS also states that trustees may not automatically reinvest proceeds earned by a DST. Instead, they’re required to distribute these funds to the beneficiaries. This helps ensure that beneficiaries are able to decide on their own what to do with the capital they earn.

In many cases, the DST sponsor will create a new DST offering after the assets of the DST are sold. This will give beneficiaries who wish to continue taking advantage of their 1031 exchange the opportunity to reinvest. However, those who wish to explore other options will have the ability to find a new investment opportunity or use their cash for other purposes.

4. Capital Expenditures

The "Capital Expenditures" rule states that trustees are only allowed to make capital expenditures for 1) normal repair and maintenance, 2) minor, non-structural capital improvements, and 3) anything that’s required by law. This ensures the trustee is able to do what is necessary to maintain the value of the real estate property while also ensuring they don’t risk the beneficiary’s investment by spending money on upgrades that may not pay off.

5. Liquid Cash Investments

When the DST has liquid cash that is not yet ready for distribution, the trustee is only allowed to place it in short-term debt obligations. Since this is considered a “cash equivalent,” doing so poses no risk to the beneficiaries or investors. Essentially, the investment vehicle is just a place to keep the cash safe until it’s time for the distribution.

6. Cash Distributions

While the DST trustee may keep some cash on reserve to cover necessary repairs or unexpected expenses, there are limits to this. Any excess funds must be distributed to the DST beneficiaries in a timely manner.

7. New Leases or Renegotiations

Lastly, the IRS forbids trustees from entering into new leases or renegotiating their current leases. This pushes trustees into less-risky, longer-term leases, ultimately creating a more secure investment for DST beneficiaries. This is one of the few areas where there are some exceptions. If a tenant faces insolvency or bankruptcy, this rule is waived.

Protect Yourself When Engaging in a 1031 Exchange

A 1031 exchange can help you defer taxes while also diversifying your investment portfolio. However, a simple mistake can quickly derail your plans. For more information, please feel free to contact our team. We would be happy to assist you in your exchange. 

This is for informational purposes only and is not an offer to buy/sell an investment. There are risks associated with investing in Delaware Statutory Trust (DST) and real estate investment properties including, but not limited to, loss of entire principal, declining market value, tenant vacancies and illiquidity. Diversification does not guarantee profits or guarantee protection against losses. Potential cash flows/returns/appreciation are not guaranteed and could be lower than anticipated. Because investors situations and objectives vary this information is not intended to indicate suitability for any particular investor. This information is not meant to be interpreted as tax or legal advice. Please speak with your legal and tax advisors for guidance regarding your particular situation.

Securities offered through Concorde Investment Services, LLC (CIS), member FINRA/SIPC. Advisory services offered through Concorde Asset Management, LLC (CAM), an SEC registered investment adviser. Insurance products offered through Concorde Insurance Agency, Inc. (CIA) Fortitude Investment Group is independent of CIS, CAM, and CIA.

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