Investing with a long-term strategy requires careful consideration of your exit plan when an investment is no longer profitable or aligns with your goals. If you’re invested in a Delaware Statutory Trust (DST), the time may come when the DST reaches the end of its cycle, typically within a five-to-10-year period. At this stage, the DST needs to liquidate the assets it acquired on behalf of investors to return their principal and any appreciation earned from the underlying property. As an individual investor, you must then decide on your exit strategy. This guide explores how DSTs function, the concept of an exit strategy, and the available options.
What is a DST?
A Delaware Statutory Trust is a legal entity established under Delaware statutory trust law, which offers greater operational flexibility. Investors, referred to as beneficiaries, own a proportional or fractional interest in the trust. This ownership entitles them to receive distributions generated by the trust’s underlying properties, such as rental income or proceeds from property sales.
DSTs are typically created by real estate companies, known as sponsors, who identify and acquire assets using their own capital. These assets are then placed within the trust. During the offering period, beneficiaries have the opportunity to purchase fractional shares, becoming passive investors who don’t have to manage the property directly but hold equitable title. The Internal Revenue Service (IRS) recognizes these interests as direct property ownership, making participants eligible for 1031 exchanges when entering or exiting DSTs.
Learn more about DSTs here.
What is an Exit Strategy in a DST?
In investing, an exit strategy refers to a plan of action to disengage from an investment. This strategy becomes necessary for various reasons. For instance, investors may choose to exit a DST after it has completed its full cycle and seek alternative investments to capitalize on the income and gains earned. During more challenging market conditions, an exit strategy might be devised to mitigate losses.
Currently, DSTs are commonly used for exchanges. They qualify as replacement property for 1031 exchanges when investors acquire a beneficial interest in the trust. Moreover, most DSTs dissolve in a manner that allows participants to complete a 1031 exchange upon their exit from the trust. To achieve this, the real estate asset(s) must be sold.
Nearly all potential exit strategies involve selling the real estate assets. Consequently, DST fund managers have a responsibility to acquire properties that generate income throughout the fund’s lifespan and maintain their resale value. This ensures that the exit strategy can be executed within the specified timeframe. To accomplish this, managers must understand the types of potential buyers their properties will attract and adopt property management practices that appeal to those buyers.
Since DST portfolios generally consist of one or more real estate properties, including high-value, investment-grade commercial properties, potential buyers for these assets typically include institutions, pension plans, ultra-high-net-worth individuals, other real estate investment funds, and real estate investment trusts (REITs). These buyers have specific requirements for the properties they consider acquiring, which DSTs often meet by acquiring high-value, investment-grade properties that appreciate over time, maintain their appeal to potential buyers, and can be sold according to the exit strategy.
As an alternative to selling the real estate assets, some DSTs may choose an exit strategy that involves contributing the property to an Umbrella Partnership Real Estate Investment Trust (UPREIT) in exchange for units of interest in the UPREIT. In return, DST beneficiaries exchange their interest in one property for interests in a larger portfolio of properties on a tax-deferred basis.
Whether a DST plans to sell or contribute its property upon completing its cycle, it is essential for investors to be aware of the expected exit strategy. This ensures that you can make informed decisions regarding your future investments.
The Three Most Common DST Exit Strategies for Investors
Once an investment has completed its full cycle, investors must consider their next steps within their long-term strategy. There are three commonly used exit strategies, outlined below. However, it’s crucial to note that each strategy comes with its own advantages and disadvantages, so it’s wise to carefully evaluate your options and seek advice from experts before making a decision.
Cashing Out
The first strategy is simply cashing out, where investors receive a portion of their capital contributions. While this may be a straightforward option for some investors, it can lead to tax consequences and other challenges that may not always be desirable. The cash-out transaction must comply with the IRS Rev. Rul. 2004-86, which allows investors to defer tax on the initially invested amount under Section 1031 of the Code for DST investments.
If an investor chooses to cash out, they may be liable for the following tax obligations upon sale:
- Federal capital gains tax
- State capital gains tax
- Depreciation recapture tax
- Medicare surtax
This strategy can trigger a significant taxable event for some investors, which is why they may consider the other two popular DST exit strategies.
1031 Exchange
Investors can also exit a Delaware Statutory Trust through a 1031 exchange, also known as a like-kind exchange. This IRS-approved process enables investors to defer capital gains taxes or the tax liability resulting from the sale of an investment property. As DSTs are considered direct property ownership for tax purposes, investors are eligible for this strategy after a DST investment has completed its full cycle.
Since this section of the tax code defers capital gains taxes that would otherwise be recognized in a sale conducted outside a 1031 exchange, some investors choose to exchange their properties repeatedly rather than sell them outright. Through a series of exchanges, investors can continue to build wealth over time through real estate investments while deferring capital gains tax. This can be sustained until their passing, at which point the DST may be transferred to their heirs with a step-up in basis.
To execute an exchange exit from a DST, investors must reinvest the proceeds from selling the relinquished property into a like-kind replacement property. This process must be facilitated by a qualified intermediary (QI) who handles the funds. The replacement property must be of equal or greater value, and the exchange must be completed within 180 days of closing on the relinquished property.
While this exit strategy allows for indefinite deferral of capital gains tax and faster wealth growth, it also means your capital remains tied up in real estate, limiting access to it. Additionally, strict requirements must be met for a 1031 exchange, such as using a qualified intermediary and adhering to deadlines for identifying and closing on the replacement property.
Some potential risks associated with entering into a 1031 exchange include:
- Lack of liquidity
- Exposure to interest rate risk
- Loss of management control
- No guarantee of projected appreciation
- No assurance of consistent monthly distribution amounts
721 Exchange
The third potential strategy for exiting a DST investment is through a 721 exchange into an UPREIT structure. Under Section 721 of the Internal Revenue Code, real estate investors can contribute their physical property to a partnership on a tax-deferred basis in exchange for interests in that partnership, without involving another 1031 exchange. The trustee has the discretion to determine whether this exchange is mandatory or optional and may require consent from DST investors.
Once the investment property completes its full cycle, an investor can opt for a 721 exchange if a REIT purchases the real estate. Depending on the circumstances, this exchange may be obligatory or voluntary. Typically, a larger REIT Operating Partnership (OP) absorbs the DST investment.
REITs often hold real estate through these OPs, allowing holders to exchange their property for an economic interest in the REIT. The OP units have the same economic rights as shares of the REIT. After a specific period, they can be converted into REIT shares, providing liquidity through a taxable transaction. Alternatively, investors can retain the units until they pass away, enabling a step-up in basis for their heirs.
However, once an investor proceeds with the 721 exchange, they forfeit the option to continue deferring taxes through a 1031 exchange. Consequently, their only alternative is to convert their OP units to REIT shares and pay the resulting tax if they wish to liquidate from the REIT.
A significant advantage of a 721 exchange is that it allows investors to divide their OP units for estate planning purposes and provide their heirs with a step-up in tax basis, effectively eliminating any deferred capital gains tax. This is why investors in the early stages of estate planning may consider a 721 exchange.
IntelliVest Wealth Management Can Help You With DSTs.
IntelliVest Wealth Management works with some of the largest investment management companies to help clients 1031 Exchange into a DST.
We offer free consultations to assess if this investment structure is appropriate for you and your goals. From there we can look at the appropriate investment companies to work with.
If you have questions if your property qualifies for these programs please contact us or call at (864) 598-0000.
This material does not constitute an offer to sell or a solicitation of an offer to buy any security. An offer can only be made by a prospectus that contains more complete information on risks, management fees and other expenses. This literature must be accompanied by, and read in conjunction with, a prospectus or private placement memorandum to fully understand the implications and risks of the offering of securities to which it relates. As with all investing, investing in private placements is speculative in nature and involves a degree of risk, including loss of your principal.
Past performance is not necessarily indicative of future results and forward-looking statements and projections are not guaranteed to achieve the results described and your actual returns may vary significantly. Investments in private placements are illiquid in nature and there may be no secondary market or ability to sell the investment should the need for liquidity arise. This material should not be construed as tax advice and you should consult with your tax advisor as individual tax situations will vary.