Delaware Statutory Trusts: Taking the Stress Out of 1031 Exchanges

There is a thief on the loose in America right now. This ravenous burglar is pickpocketing virtually every American, and he continues to spread his tentacles into every corner of the land. His activity could easily be the difference between you enjoying steady cash flow, creating wealth, and choosing the life you want in retirement…. or scraping along through life.

Who is this bandit? It’s the taxman.

And if you think he’s gotten out of control in the past century, wait until you see what’s coming. The massive fallout of a post-pandemic world—a world that includes job losses, business closures, social unrest, and money printing gone awry—will certainly fuel his influence.

And he’ll continue to rob you blind.

But there’s some great news…

The same people who created and perpetuate this monster have designed an array of loopholes that allow them (and their pals) to largely elude him. And thankfully for many of us, commercial real estate investors are among the chief beneficiaries of these get-out-of-jail-free cards.

I was speaking with a friend who has succeeded in the commercial real estate world for decades. He said:

When the President and Congress got together in 2017 to overhaul the tax code, it was rumored they would take away one of the real estate investor’s most powerful tax deferral strategies: the 1031 exchange.

And they did take it away—for everyone except real estate investors.

Real estate investors were the greatest beneficiaries of the new tax law, with surprising opportunities to accelerate tax write-offs from depreciation and defer or avoid taxes through Opportunity Zones. And our beloved 1031 exchange was maintained.

While we love and appreciate the 1031 exchange, this legal provision has some serious pitfalls. I’m going to show you how to remedy many of them in this post.

What Is a 1031 Exchange, Anyway?

A 1031 exchange is a swap of one investment property for another that allows capital gains and depreciation recapture taxes to be deferred. There are limitations, however…

Properties must be held for business or investment purposes
Properties must be considered like-kind (real estate exchanged for real estate)
There is no limit on frequency or number of 1031 exchanges
45-day rule: Time limit to name three (or more) replacement properties
180-day rule: Time limit to close on one or more properties

Advantages of the 1031 Exchange

The 1031 exchange provides wonderful benefits to the real estate investor who knows how to utilize it.

I asked my friend, Nathan Webb of American Accommodators about his view on 1031 exchanges. He said, “The single biggest benefit of a 1031 exchange is the ability to roll 100% of your equity and appreciation into bigger and better assets, creating a snowball effect of equity and cash flow.”

A 1031 exchange enables you to:

Leverage/Purchasing Power: Reinvest capital gains and depreciation recapture taxes in your assets rather than pay the IRS. It is widely known that growing your portfolio with deferred taxes can significantly compound your fortune and its corresponding cash flow. Here is an example from Realized1031.com:

Consolidation. In some cases, investors can choose to exchange a portfolio of smaller, hard-to-manage assets into a larger commercial property. For example, many investors choose to exchange a collection of single-family rentals into a single commercial property.
Management. Exchanges from a portfolio of smaller assets into one large one often lower management hassles, risks, and costs.
Reset depreciation schedule. Accelerated depreciation will eventually mean lower tax write-offs. By exchanging a property for a replacement property, investors can start with a new depreciation schedule and increase tax write-offs.
Increased cash flow. Some investors trade non-performing real estate (like land) for an asset that generates cash flow.
Relocation. Some 1031 exchange investors replace their current property with a property in a different state.
Swap ‘til you drop to avoid taxes altogether. In most cases, exchanged assets at the time of death can provide a wonderful gift to heirs: a reset basis resulting in no payment on years (or decades) of deferred capital gains and depreciation recapture taxes. To be sure, if you mess this up, you’ll cost yourself and/or your heirs dearly. Not a great way to be remembered!

Disadvantages of the 1031 Exchange

Every silver cloud has a dark lining, right? (Or something like that.) The beloved 1031 exchange is no exception. We’ve spoken to many real estate investors who attempted to do a 1031 exchange but failed. There are quite a few ways to fail, and I’m writing so that you will not fall into one of these traps.

I once got a call from George, a potential 1031 exchange investor in Harrisonburg, Virginia. He was 30 days into his initial 45-day selection window and hadn’t found any good replacement property options.

George had worked for decades in his furniture business. Preparing for retirement, he had sold his downtown furniture store for $800,000. This would be a major portion of his retirement, so he wanted to save on taxes. He tentatively decided on an overpriced fourplex as a replacement, but when he ran the numbers on the eve of the deadline, he learned he would be upside down on payments. And he would be spending his golden years as a landlord. This was not his idea of an idyllic retirement.

George abandoned his 1031 exchange and paid the hefty tax bill. Also not a great way to start your golden years.

Multiple rules and regulations. To pull this off, you must follow the fund-handling guidelines and calendar deadlines specified by the law. This cannot be done casually.
Tight timeline. Due to the stringent deadlines, investors are under significant pressure to find the right replacement property. This can result in the pressure to overpay or acquire a subpar property, which can result in poor returns (or worse) and a lot of management hassles.
Lack of negotiating power. In many states, a 1031 Exchange investor must disclose this fact on a purchase contract. This may cause sellers to harden their negotiating positions, especially regarding inspection items as deadlines draw closer. They believe you will bend to avoid the tax.
Replacement property price and debt match. 1031 Exchange investors typically seek a replacement property of a similar price and debt load to avoid boot – which causes a tax for the mismatch. This significantly complicates an already time-constrained process.
Potential of increased future tax rates. Some believe that potentially higher future tax rates offset the compounded gains achieved by deferring taxes. There is no way to know the future, but most calculations show that deferring and compounding growth pays off in the long run, especially for those using the swap ‘till you drop approach.

Like I said earlier, while we love and appreciate the 1031 exchange, this legal provision has some serious pitfalls. I’m going to show you how to remedy many of them below.

How?

Through investing in a Delaware Statutory Trust as your 1031 exchange replacement property.

Nathan Webb said, “The 45-day identifier time period has always been stressful for exchangers. Adding a DST as one or two of the options has taken much of the pressure off of the exchanger and allowed them to more confidently go into the 180-day closing period.”

What Is a Delaware Statutory Trust?

A Delaware Statutory Trust (DST) is an ownership model that creates a legal entity allowing co-investment among sponsors and accredited investors to purchase beneficial interests in either a single asset or a portfolio of properties. DSTs are tax-deferred and 1031 exchange-friendly.

Yes, a DST is a legal entity constructed under Delaware law. But despite the name, neither the property nor the investors need to be located in the state of Delaware.

Multiple investors pool their equity into a DST, and each owns a fractional share of a trust, which in turn owns a property. Ownership in a DST is proportionate to the amount invested by each investor. Investors are deemed as “beneficiaries” of the trust. As with a tenant-in-common (TIC) arrangement, the IRS treats DST interests as direct property ownership, thus qualifying for a 1031 exchange and other tax benefits.

The DST shields investors from property management and property-related liabilities. This is called Bankruptcy Remote. This means the DST prevents creditors of individual beneficiaries from placing liens against the property, which provides greater security to lenders and other investors.

DSTs are typically financed with non-recourse debt. This limits a lender’s remedies on the DST’s underlying property. But most DST investors aren’t that concerned about this because beneficiaries of the DST do not carry any personal liabilities for the debt. Only the DST organizers sign on the debt.

What Are the Advantages of a Delaware Statutory Trust?

The DST is a beautiful solution to many of the disadvantages and constraints under the 1031 exchange. Let’s look at some of the advantages of the DST.

1031 exchange deferral of capital gains and depreciation recapture. This provides the opportunity to defer (or eliminate) taxes, increase your cash flow, and grow your wealth.
Elimination of pressure. A quick decision, poor negotiating leverage, and poor choices often lead to an over-priced or risky acquisition. This is avoided under the DST arrangement.
The opportunity for passive income. Many investors quit their job to invest in real estate… just to end up with another job managing the real estate. A DST allows investors to replace their job with a passive investment that provides mailbox money and appreciation.
Professional management. In addition to avoiding hassle and risk, investors enjoy the opportunity to employ an expert asset and property management team.
Elimination of rogue investor risk. Tenant-in-common (TIC) structures operate under unanimous consent. This runs the risk of one investor spoiling everything. DSTs are managed by a third party, eliminating this possibility.
Size match of asset and debt risk eliminated. While a typical 1031 exchange investor seeks an asset close in price and leverage, this issue is eliminated with a DST since the trust can accommodate a wide range of investment levels.
Diversification. Proceeds from a high-priced relinquished property can be easily reinvested into several DSTs.
Simplified investment process. The typical stress-laden process of locating, negotiating, financing, and closing on a replacement property… not to mention operating it… is eliminated by replacing into a DST.
Real property interest. Pass-through income, tax deductions, and appreciation flow directly through to the investor (unlike investing in a REIT or some other investment vehicles).
Stabilized cash flow. DST assets are stabilized and generate steady, predictable cash flow.
Appreciation. In addition to cash flow, investors receive 100% of the appreciation and the gains from principal paydown at the termination of the DST.
Limited liability. The DST operator, not the investor, signs on the debt and assumes all liability for repayment. The investor is not liable.
Debt capacity. A typical 1031 exchange investor assumes debt with their replacement property. Without this debt, a DST investor has the capacity to assume additional loans for other projects.

What Are the Disadvantages of a DST?

A DST is not for everyone. You should count the cost and weigh the downsides of investing using this structure.

Loss of control. Most 1031 exchange investors go from controlling Asset A to controlling Asset B. If you feel the need to stay in control, this is not for you.
Limited upside. Value-add real estate deals often provide investors with significant upside through appreciation. Due to their regulations, DSTs only acquire and operate stabilized assets. These are predictable assets that have most of the upside potential… along with the corresponding drama… already wrung out of them.
Illiquid. There is no established secondary market for DST interests. Like many real estate investments, investors need to evaluate whether they want to be in this investment for the duration.
High sales commissions and legal fees. DSTs are usually marketed through broker-dealers who charge hefty commissions. There are DSTs that are marketed directly, but they are obviously harder to find.
Accreditation. Delaware Statutory Trusts accommodate accredited investors. This leaves a lot of investors unable to access this powerful option.

Case Study

Lonnie was fed up. He was a successful attorney by day and a real estate investor in his spare time. He always sought out passive investment opportunities and he’d been pretty successful at landing them. But the stakes just went up…

Lonnie started out with a successful triple net lease restaurant in the ’80s. When he went to sell in the early ’90s, he learned about the recently codified 1031 exchange. He had substantial gains and was delighted with the opportunity to defer taxes. Lonnie was able to exchange into a medium-sized apartment building.

After managing apartments for a few years, Lonnie realized he liked the asset class but hated being a landlord. (His income suffered from taking time off to deal with the three Ts: toilets, tenants, and trash.) In 2007, right before the crash, he was able to sell this property at a premium and exchange it into a strip center with only a handful of hopefully stable tenants. Being a landlord with only eight commercial leases couldn’t be so bad, right?

He was right. At least about the toilets and other landlord hassles. Fast forward over a decade. Sadly, a few tenants were shut down during COVID-19 and they closed their doors for good. It looked like more would follow, and he was faced with a choice: Convert the vacant boxes to self-storage or sell to the anchor tenant who’d been asking him about buying the building for years.

Lonnie was retiring at the same time, so the effort to convert to and then operate a self-storage facility seemed less than appealing. He contacted the buyer and went under contract, setting up a quick sale.

Then, the bad news came.

After meeting with his CPA, Lonnie learned that all of those depreciation recapture taxes plus the capital gains accumulated in three appreciated properties would all come back to bite him. Fortunately, Lonnie knew the solution: another 1031 Exchange.

The good news about his 1031 exchange: He had just retired and had the time to scour the nation for replacement properties.

The bad news about his 1031 exchange: He had just retired, and this is not the way he envisioned spending his first months of retirement.

Within a few days, Lonnie was already tired of searching through hundreds of listings sent by a variety of brokers, on Loopnet, and even Craigslist. The vast majority didn’t meet his criteria. It was almost impossible to find one property that matched so many variables. He was looking for:

The right asset type
The right location
The right price range to match his relinquished property
A fair price in an inflated market
An asset he could finance at the right level
The right timing

Despite these challenges, Lonnie persisted in an increasingly frantic effort to avoid paying a boatload of tax. It didn’t help that the nation was engulfed in a pandemic, and even the properties that looked interesting were hard to travel to, to see in person.

One day he sunk into a depression. After another almost sleepless night, he realized that even if he succeeded, most of the properties would require him to continue to do what he vowed to never do again: play the role of a landlord—collecting rent, filling vacancies, paying bills, doing financials.

Lonnie’s golden retirement plans were crumbling before his eyes.

That’s when Lonnie heard about the Delaware Statutory Trust.

Lonnie was hesitant at first. Was this really legal? After reading and searching the web, and speaking with others who had gone down this path, Lonnie started to relax. It dawned on him that a DST would solve his problem.

Lonnie downloaded several offerings, and he did his own research on the operators, the properties, and the legal structure. As an attorney, he read every word of each PPM. He spoke to references, did background checks, and he thoroughly convinced himself this was the best path for him.

Lonnie closed on the sale of his commercial property through a 1031 exchange, and feeling no time pressure, he named three DSTs as potential replacement properties. A few weeks later, he made a final decision and invested in two of them. One was a self-storage DST and the other a mobile home park DST. By going directly to the operator/manager, Lonnie was able to save on broker-dealer fees and commissions.

I spoke to Lonnie the other day. I reached him on his mobile phone, and he was playing tennis at his beachfront condo. His first two monthly checks had arrived like clockwork, and he said the DST manager was doing everything as promised. He sounded happy, and he is enjoying his retirement.

DSTs are still fairly new to the 1031 exchange arena, but they have completely changed the landscape. While they are not for everyone, DSTs effectively allow our investors to have a turnkey exchange option on the table at almost any time.

Are you interested in learning more about Delaware Statutory Trusts? Do you have a pending 1031 exchange or are you planning one?

Tell us how you’re dealing with it.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.