Investors should always consider a long-term strategy. In the event that an investment is no longer profitable or does not meet your needs, you may be considering an exit strategy. This may happen when a Delaware Statutory Trust (DST) comes full-cycle, which usually occurs within five to ten years.
Upon disposing of the assets it purchased on behalf of investors, the DST will return investors’ principal as well as any appreciation experienced by the underlying property. The individual investor will then decide how to exit the DST. In this guide, you will learn what an exit strategy is, how DSTs work, and what options you have.
DST: What Is It?
A Delaware Statutory Trust is a legal entity created under Delaware statutory trust law. In addition to allowing the entity to operate more flexibly, this law also allows for more information sharing. An investor owns a pro rata interest in the trust, allowing him or her to receive distributions from the trust’s underlying properties, such as rental income or property sale proceeds.
Companies that sponsor DSTs are generally real estate companies that identify and acquire assets using their own capital. Beneficiaries can become passive investors by purchasing fractional shares during an offering period. In other words, they do not have to manage the property but only maintain an equitable title to it. DSTs qualify for 1031 exchanges upon entry and exit due to the IRS’s classification of these interests as direct property ownership.
DST Exit Strategies: What Are They?
The purpose of an exit strategy in investing is to remove oneself from a situation, and it may be necessary for various reasons. The income and gains earned from a DST may be used to invest in other investments under favorable market conditions. It may be necessary to develop an exit strategy when market conditions become more challenging.
The use of DSTs for exchange is common today. Exchangers can use DSTs as replacement property for 1031 exchanges if they acquire a beneficial interest in the trust. The most common DST dissolves in such a way that exchangers can perform a 1031 exchange after exiting the trust. This requires the sale of real estate assets.
Real estate assets are almost always sold as part of potential exit strategies. To ensure the fund’s exit strategy is achieved within the stated timeframe, DST fund managers must acquire properties that will generate income during the life of the fund. Managing properties in a way to attract the type of purchasers their properties will attract is the key to achieving this goal.
The following types of potential buyers of DST portfolios generally include those interested in high-quality, investment-grade properties in their portfolios:
- Organizations
- Plans for pensions
- Individuals with an ultra-high net worth
- Investing in other real estate funds
- Trusts that invest in real estate (REITs)
This type of buyer has specific requirements for acquiring a property. A DST generally seeks out high-quality, investment-grade properties that are expected to appreciate over time and attract buyers, as well as be sold in accordance with its exit strategy.
In order to be sure you are in a position to make any future investments you want, you should know the expected exit strategy for DSTs at the end of their cycles, whether they plan to sell or contribute their property.
Exit Strategies for DST Investors: Three Common Methods
The next step in a long-term strategy should be considered once an investment has completed its full cycle. The following are three common exit strategy options. Be sure to weigh your options carefully and speak with an expert before deciding which strategy is best for you. Each of these strategies has advantages and disadvantages.
Making a withdrawal
An investor can cash out some of their capital contributions by cashing out. The simple option of cashing out may be appealing to some investors, but it comes with tax consequences and other challenges as well. It is due to the Rev. Rul that the cash-out transaction must be compliant. Under section 1031 of the Code, investors can defer tax on their initial investment under IRS ruling 2004-86.
Upon selling an investment, investors may have to pay the following taxes:
- Capital gains under federal law
- State capital gains
- Depreciation recapture tax
- Medicare surtax
- Some investors may consider the other two most popular DST exit strategies if this strategy triggers a significant taxable event.
1031 Exchange
A 1031 exchange can also be used to exit a Delaware Statutory Trust. This IRS-approved process, also known as a like-kind exchange, enables investors to defer capital gains taxes and tax liabilities on investment property sales. Following a DST investment full-cycle event, investors are eligible to use this strategy since DSTs are considered direct property ownership for tax purposes.
Rather than selling their properties, some investors choose to exchange them – and continue to exchange them over and over – instead of selling them because a 1031 exchange only defers capital gains taxes. The DST may be passed on to the heirs at a step-up in basis through this process for years until the investor passes away.
Through a DST exchange exit, investors can defer capital gains tax on their real estate investments and accumulate wealth over time. A qualified intermediary (QI) must be used to handle the funds from selling the relinquished property in order to be eligible for this exchange. In this case, the investor must exchange the relinquished property for a property of equal or greater value within 180 days of the closing.
Capital gains tax can be deferred indefinitely and your wealth can grow at a faster rate. You cannot access your capital if you keep it in real estate. Also, you must use a qualified intermediary (QI) and meet the deadlines for the replacement property’s identification and closing before conducting a 1031 exchange.
