How is a Delaware Statutory Trust (DST) taxed by the state and the federal government?

How is a
Delaware Statutory Trust taxed?

General Taxation Rules

In general, for the investors of a Delaware Statutory Trust (DST), all the distributed gains from their DST are taxed under the ordinary income tax codes. If the property invested via DST is out of state, the trust owner should file a state income tax return in that particular state. If the state at which the property is located does not collect income tax, then there is no need to file a state income tax return. As of now, there are seven states in the US that do not impose income tax: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming.

Rules get slightly complicated for the purpose of federal income tax. One of DST’s most captivating features is that it possesses its own separate legal personality. Hence, in accordance with the federal tax regulations, DST can be taxed as either a trust or a business entity. One pervasive misconception is that just because DST (Delaware Statutory Trust) has the word “trust” in its name, it does not necessarily mean it would be categorized as a “trust” by default for the federal tax purpose. § 301.7701-4(c)(1) is the legal authority for the critical distinction between a trust and a business entity. In essence, the core distinction flows out of the trust agreement which a DST is founded upon.

Indirect and Direct Investment

Before jumping into the detailed legal definitions of trust and business entity, it is better to clarify the differences between indirect and direct investment at first. Direct investment can be discerned by its capability in identifying and demonstrating investors’ ownership of a particular asset, including real property. On the other hand, an indirect investment normally refers to the situations that a group of investors put together a sum of money for unspecified investment activities, including buying or selling assets without ownership attached. In other words, the ownership interests in indirect investments are crafted to permit investors to fulfill their varying investment objectives that are not neatly identifiable as opposed to direct investments.
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Trust

The US regulation stipulates that “An investment trust with a single class of ownership interests, representing undivided beneficial interests in the assets of the trust, will be classified as a trust if there is no power under the trust agreement to vary the investment of the certificate holders.” By analyzing the examples provided in the statute book, the definition can be further interpreted as that so long as the ownership interests are incidental to the trust’s purpose of facilitating direct investment in the assets of the trust, then the trust shall be classified as a trust.

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Business Entity

The statutory definition of a business entity is that “An investment trust with multiple classes of ownership interests ordinarily will be classified as a business entity under § 301.7701–2”. In detail, if the trust ownership is not incidental to any purpose of the trust to facilitate direct investment, then accordingly, the trust shall be classified as a business entity.

However, an exception is provided that if “an investment trust with multiple classes of ownership interests, in which there is no power under the trust agreement to vary the investment of the certificate holders, will be classified as a trust if the trust is formed to facilitate direct investment in the assets of the trust and the existence of multiple classes of ownership interests is incidental to that purpose.” Hence, it appears that in terms of categorizing a DST as a trust or a business entity, it is not pivotal to consider whether the ownership interests are held by however many classes. Rather the key determinator is whether a power, under the trust agreement that a DST relies upon, can vary the investment which could steer away from facilitating direct investment in the assets of the trust and the existence of ownership interests that are incidental to that purpose. If the answer is yes, then such a DST shall be taxed as a business entity.

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Taxed as Trust v Business Entity

There are two types of trust for the purpose of federal tax. They are irrevocable and revocable trust. If one’s DST is categorized as a trust rather than a business entity, then it should be considered as an irrevocable trust. The rationale is that a DST has its own separate legal personality, therefore, the existence of a DST will not be terminated or dissolved by beneficial owner’s affairs, such as death, bankruptcy, or dissolution. In theory, it shall continue eternally, namely, a DST cannot be revoked or amended by a trust owner. In practice, the Internal Revenue Service (IRS) will assign unique tax identification numbers to most irrevocable trusts. The income of an irrevocable trust can be filed with Form 1041. The federal income tax on trust is shockingly harsher than personal income tax. For instance, in 2012, the federal taxable income of $11,650 is 35% for trust income as opposed to only 15% for single taxpayers. 

On the other hand, when a DST containing two or more owners is classified as a business entity, for federal tax purposes, it would be taxed as a partnership, “unless it is treated as a corporation under § 7704 or elects to be classified as a corporation under § 301.7701-3”.

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DST with 1031 Exchange

In 2004, DSTs were approved for the 1031 Exchange. The combination of the Delaware Statutory Trust (DST) and the 1031 Exchange can be a powerful tool for ambitious investors. It allows an investor to defer his or her capital gains tax and relocate the money to higher profit properties through DST. Per NES Financial data, almost $1billion growth of scrutinized 1031 sales in association with Delaware Statutory Trust investments was recorded between 2017 and 2018. The real properties invested through DSTs must strictly comply with the 1031 Exchange regulations. It includes like-kind real estate property requirements. It means that an investor enjoys tax deferral by a like-kind exchange of real estate properties for the purpose of business and investment. The like-kind property must be located in the United States. Primary residence does not qualify. Form 8824 is the proper document to report an investor’s 1031 Exchange. The form provides further detained instructions to navigate the investor through the process. It is worth noting that in order to enjoy tax deferral under Section 1031, like-kind real estate must be identified within 45 days and acquired within 180 days after the prior property has been sold. It is also worth mentioning that proceeds from the investment real estate sale do not have to be invested fully in one DST property. It would be wise to distribute it across multiple DST properties. Such a diversified portfolio by taking advantage of DST’s fractional ownership feature can surely minimize the investment risks.

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