1031 Exchange and DST Investment

The answer depends on the need of your business goal. Overall, DST has a load of eye-catching advantages as an investment tool. It is fairly easy and inexpensive to be created. It provides great flexibility to tailor an investor’s desire through the DST Trust agreement. Because DST is a separate legal entity, it will not terminate or dissolve by beneficial owner’s affairs. In addition, any liabilities incurred under DST are solely limited within DST itself. Finally, the DST trust agreement is not required to be approved by any authority in the State of Delaware. 

1031 Exchange refers to the IRS Tax Code section 1031. It allows an investor to exchange and reinvest properties within a certain period of time to defer paying capital gains tax. In other words, it preserves and maximizes the investor's financial power to reinvest other like-kind properties for larger economic growth. 

REIT stands for Real Estate Investment Trust. It is an income-generating entity that invests in various properties and distributes dividends to its investors. REIT is a public entity under the governance of the Securities and Exchange Commission (SEC). The investors of REIT are not considered as the owners of the REIT properties. Hence, they cannot enjoy the benefits of the 1031 Exchange. In other words, unlike DST, REIT investors are subject to capital gains tax after each property sale. On the other hand, unlike REIT, DST is an illiquid investment. It means that the investment under DST cannot be readily converted into cash. It has a higher risk of substantial loss in value due to a lack of ready and willing investors in the market in a short term.

Apart from a drawback of DST as an illiquid investment, it is worth mentioning its renown “Seven Deadly Sins” as follows:

1. DST Trustee is restricted to accept more financial contributions to the Trust after the offering is closed. It is to protect the original investors’ ownerships from being diluted.
2. Because the beneficiaries of DST cannot participate in the operation of the Trust, the Trustee is prohibited to borrow or negotiate new loans which could alter the financial liabilities of the beneficiaries.
3. The profit gained from DST cannot be used by the Trustee to reinvest. It must be distributed among the beneficiaries based on the agreement.
4. The Trustee has limited power to spend money on maintaining the real estates property, such as standard repairs and minor non-structural changes. However, the Trustee cannot upgrade the property like an investment.
5. Between distribution dates, cash retained in the DST can only be invested in short term debt obligations. In the view that the short-term debt can be converted back to cash easily for the upcoming distribution.
6. An amount of cash in the DST is permitted to be retained from distribution. However, earnings and proceeds must be handed over to the beneficiaries promptly on the agreed dates.
7. In align with preventing the Trustee from risking beneficiaries’ interest, the Trustee is prohibited from renegotiating the existing lease or entering a new lease, unless a tenant enters into bankruptcy or insolvency.

The profit generated by Delaware Statutory Trust (DST) must be distributed on an agreed regular basis to the beneficiaries. Such profit is subject to local state tax code. If your DST properties are located in another state, the state income tax return of that state should be filed. In general, you should receive an operating statement every year. It summarizes the profit and expenses related to the DST property. Based on this statement, you can use Schedule E to file your tax return. Again, where 1031 Exchange applies, investors can defer paying capital gains tax related to the swap of like-kind properties.