REIT vs DST

The Money Machine of REIT

REIT is the abbreviation for Real Estate Investment Trust. The US REIT was created in 1960 by the enactment of the Real Estate Investment Trust Act. According to the data collected on Nareit, REIT takes up a significant portion of US overall real property investments. The total equity market capitalization of the FTSE Nareit All REITs Index is worth $1.4 trillion. In 2019 alone, the dividend income of $65 billion was distributed to the shareholders in relation to REIT activities. In addition, REITs raised $109.4 billion in public market offerings in 2019 and collectively own more than $3.5 trillion in gross assets across the US, with stock-exchange listed REITs owning over $2.5 trillion in assets. More than 516,000 properties in the US are owned by REITs. As a result, REITs’ investments across the US have benefited millions of Americans. More than 145 million Americans live in households with REIT investments through their 401(K) and other investment funds. Over the last 20 years, REIT total return eclipses the S&P 500 Index, other indices, and the rate of inflation.

Generally speaking, there are four types of REITs: Equity REITs, mREITs, Public Non-listed REITs, and Private REITs. The most common one in the market is Equity REITs which are publicly traded. Because most REITs are listed on major stock exchanges, individuals can invest by purchasing shares of a REIT just like buying stocks.

The dividends distributed from REITs are the primary methods for their shareholders to obtain their financial interests. Required by law, at least 90% of REIT’s income must be transferred to its shareholders. Shareholders then pay their income tax on the dividends they received. In other words, REIT dividends are taxed as regular income. The most common model of REIT’s revenue is from rent collection through leasing its purchased properties.

What Exactly is REIT?

The United States Code Title 26 provides the statutory definition to answer this question. In Section 856, it prescribes the qualifications of a corporation, trust, or association that can be considered as a REIT.

The entity is managed by one or more trustees or directors

(see 26 §§ 856(a)(1));

The beneficial ownership of which is held by 100 or more persons

(see 26 §§ 856(a)(5));

At least 95 percent (90 percent for taxable years beginning before January 1, 1980) of its gross income is derived from dividends; interest, and rents from real property

(see 26 §§ 856(c)(2));

At least 75 percent of its gross income is derived from rents from real property, interest on obligations secured by mortgages on real property, gain from the sale or other disposition of real property

(see 26 §§ 856(c)(3));

At the close of each quarter of the taxable year at least 75 percent of the value of its total assets is represented by real estate assets, cash, and cash items

(see 26 §§ 856(c)(4)(A));

Have no more than 50% of its shares held by five or fewer individuals.

To be part of a REIT, investors can contribute through purchased shares. In other words, investors are usually the shareholders of a REIT. It signifies that the investors bear the limited liability of the debts of the REIT up to the value of their shares. Thus, the worst scenario for a REIT investor is to lose all the share money he or she puts in.

Incompatibility with 1031 Exchange

The 1031 Exchange is named after the Internal Revenue Code (IRC) Section 1031. Under section 1031, an investor enjoys capital gains tax deferral through a like-kind exchange of real estate properties for the purpose of business and investment. However, instead of real property, REIT is categorized as a security. Thus, by the strict definition of the 1031 Exchange, REIT is not qualified, since 1031 does not permit exchange between a piece of property and a security.

DST v REIT

The Delaware Statutory Trust (DST) is based under Chapter 38, Part V, Title 12 of the Delaware Code. The related statutes are from 12 §§ 3801 to 3862. Contrary to REIT, there are a host of advantages of choosing DST.

First and foremost, DST is created by a governing document, known as a trust agreement. Such an agreement is crafted by all the trust owners. Consequently, it guarantees maximum freedom for investors to closely tailor their business interests and vision. The Delaware Statutory Trust Act (DSTA) has almost no legal constraints on the format and content in terms of the governing document. For example, trust agreement does not have to be drafted in English and no approval is required from any authority in Delaware for the submission of such agreement. It is not hard to see that in terms of privacy and customization, DST has a lot more to offer than REIT. It is logically no surprise that REIT, due to its public trading feature, demands more transparency and public scrutiny for the purpose of protecting the shareholders’ interests. Unlike REIT, DST has no requirement on the minimum number of its beneficial owners. A DST is normally managed by a trustee who is either designated or through a predetermined procedure laid out in the governing document.

Most REITs are registered as corporations. The laws upon corporations are notoriously complex. For the purpose of regulation compliance, it almost always requires professional consultancy for any REIT activities. However, DST is mainly under the principle of freedom of contract, it enjoys almost no government restrictions. The trust agreement is the primary legal force behind the trust’s daily operations. Hence, the trust owners do not have to possess an extensive amount of legal knowledge about government regulations.

In 2004, DSTs were approved by the 1031 Exchange. Any real property investments through DST can automatically benefit capital gains tax deferral, subject to the limitation of like-kind property rules. However, as explained earlier, this option is not available for REIT investors, at least not directly. Pursuant to Internal Revenue Code section 721, it is plausible for the investors of REIT to use DST as a stepstone for the purpose of capital gains tax deferral offered in the 1031 Exchange.

As for liabilities, the Delaware Statutory Trust Act (see 12 §§ 3805(b)) provides that “no creditor of the beneficial owner shall have any right to obtain possession of, or otherwise exercise legal or equitable remedies with respect to, the property of the statutory trust”. It puts DST on the same level of protection as REIT over the investors.

The only downside of DST is that unlike REIT’s transferable shares, 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. However, there are some ways to reduce the risks. For instance, proceeds from the real estate sale do not have to be invested fully in one DST property. It would be wise to distribute them across multiple DST properties. Such a diversified portfolio by taking advantage of DST’s fractional ownership feature is a common practice among the DST owners.

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