Delaware Statutory Trusts (DSTs), otherwise known as an Unincorporated Business Trust, are legally recognized trusts that allow (1) accredited investors to (2) defer capital gains through a 1031 exchange and (3) invest in a fractional interest in (4) large, institutional quality and (5) professionally managed commercial properties. While DSTs are created by filing a Certificate of Trust with the Delaware Division of Corporations, the business purpose for which they are formed is not restricted to the State of Delaware. Trusts are fiduciary arrangements that allow a third-party, known as a trustee, to hold assets on behalf of a beneficiary or beneficiaries. In this article, I will break down the various components of a DST and explain how, for some investors, they can be an excellent alternative to a traditional 1031 exchange.
(1) Accredited investors
Delaware law does not require DSTs to be registered with the Securities & Exchange Commission (SEC), which is why they are only available to accredited investors. Private trust agreements govern the relationship between the trustee and beneficiaries; including distribution of the trust’s assets, voting rights, etc. There are no regulations or restrictions on the format or phraseology of the governing agreement or limits to the powers of the trustee. As a result, investors must be sophisticated enough to analyze and understand the terms of the trust agreement so that they can accurately calculate their projected return, identify the risks associated with the existing language, and determine whether or not to invest in the particular entity.
(2) Defer capital gains through a 1031 exchange
Delaware Statutory Trusts invest in real property and ownership interests are available for purchase to accredited investors, many with minimum investments as low as $100,000. Because DST real property assets are held for investment purposes they qualify as “like-kind”/replacement properties under Section 1031 of the Internal Revenue Code. Therefore, investors can defer capital gains by reinvesting the money in a DST through a 1031 exchange.
(3) Invest in a fractional interest
The traditional 1031 exchange requires a seller to reinvest capital gains into a “like-kind” property or properties of equal or greater value within certain time limits and, while the timeframes don’t change, DSTs allow investors to take the entirety of their gains and pool them with other investors’ funds. For example, if an investor has $100,000 of capital gains they could invest in a DST investment valued at $10,000,000, effectively purchasing a 1% interest in the asset. Investors are not partners but rather individual owners within the trust and, as a result, receive their percentage share of cash flow income, tax benefits, etc. Liquidity is a potential issue as many investments have long holding periods (5-10 years) and owners’ ability to transfer or sell their interests may be prohibited or limited by the trust agreement.
(4) Large, institutional quality
Because DSTs allow investors to pool funds they are able to invest in properties that were previously only available to the ultra-wealthy and to large institutions such as pension funds, insurance companies, etc., hence the term “institutional quality.” Examples of such investments include hundred plus unit multi-family apartments, high-rise office buildings, industrial projects, shopping centers, etc. The stability and diversification inherent in such properties is reflected in their price tag.
(5) Professionally managed commercial properties
A major reason that property owners may hesitate to sell an investment property despite positive market conditions is that they do not want to pay capital gains taxes but also do not want to have to find a replacement property that they have to manage. They don’t want to be a landlord anymore. One of the greatest features of Delaware Statutory Trusts is that they are held, managed, and administered by the trustee. This is another reason DSTs are reserved for accredited investors. The quality of the “professional management” is paramount to the success of the investment. Trustees should be qualified and vetted by investors to ensure their competency and experience. Ideally, trustees are sufficiently connected and knowledgeable to be able to identify analyze investments regardless of location and structure acquisitions in a way as to maximize the investment’s return. They should also manage the asset efficiently; minimizing operating expenses while adequately maintaining the common areas and building systems so that the property maintains its value and provides the highest return to investors.
Delaware Statutory Trusts provide accredited investors with the ability to defer capital gains and invest in institutional quality investments without the responsibility of managing the properties, themselves. Depending on the skill, experience, etc. of the trustee, beneficiaries may have the opportunity to invest in markets outside their area of expertise where returns are higher or where there is a greater likelihood of appreciation either through effective management or capital investments. Finally, DSTs provide a “fallback plan” if sellers are unable to identify a suitable or desirable replacement property within 1031 exchange timeframes.