Managing Partner at Perch Wealth, specializing in 1031 exchanges and tax-advantaged alternative investments.
Real estate is becoming increasingly mainstream as a form of investment. The high barriers to entry that once existed have been reduced due to new investment options such as fractional ownership through Delaware statutory trusts. This opens up potential tax benefits associated with real estate investments.
Under current IRS rules, investors can sell a property for a profit and use a 1031 exchange to defer paying capital gains tax by reinvesting the proceeds in another “like-kind” asset. This allows investors to attempt to grow their real estate portfolios while deferring payment on gains, sometimes indefinitely.
However, using a 1031 exchange can be complex, with numerous rules, restrictions and time limitations. Additionally, those who invest in real estate through a 1031 exchange must assume the responsibility of managing and maintaining the property, which may not be suitable for those seeking passive income.
This article compares the advantages and disadvantages of investing in a DST versus using a 1031 exchange to directly purchase property.
What Is A 1031 Exchange?
Section 1031, named after its reference in the Internal Revenue Code, enables investors to defer paying capital gains tax on the sale of a business or investment property by reinvesting the proceeds into a similar investment. This increases the purchasing power of the investor as they can utilize the equity from the sale for investment in the new property.
1031 exchanges seem straightforward, but are complicated in practice. The most common type of 1031 exchange is a “delayed exchange,” where a third-party “qualified intermediary” facilitates the sale of the property and ensures the proceeds are used to purchase another like-kind property. Upon receiving the proceeds from the sale, the investor has 45 days to identify a replacement property to buy. To qualify for tax-saving benefits, the investor must close on the replacement property within 180 days from the date of closing on the relinquished property.
Once the new like-kind asset is acquired, the investor typically becomes actively involved in property management and operations.
What Is A DST?
A DST is a popular investment vehicle for fractional real estate ownership, offering passive ownership for investors. It operates similarly to a limited partnership, where multiple investors pool their capital to invest alongside a sponsor who manages the investment. A DST is a legal entity providing limited liability and potential pass-through income to investors, such as cash distributions to the owners. DSTs are a legally recognized way for investors to complete a 1031 exchange.
Unlike limited partnerships or LLCs, the DST sponsor acquires the properties to be offered within the trust using their own capital, conducting due diligence, sometimes securing long-term debt and making the offering available to investors. The sponsor receives a fee for structuring and overseeing the investment on behalf of the investors.
There are two main ways to invest in a DST: direct cash investment or a 1031 exchange. Someone selling a property can roll the sale proceeds into the DST in the same way as a 1031 exchange for direct property purchase. The key difference is using a 1031 exchange for a DST investment allows the investor to transition from an active to a passive role, diversify their real estate holdings and retain possible tax benefits of direct real estate ownership.
Potential Advantages Of Investing In A DST Compared To Direct Ownership
While many investors choose real estate to diversify their portfolios and attempt to earn passive income, direct ownership can be misleading. Despite the potential for passive income, direct ownership often requires active management, including due diligence, hiring professionals, securing financing and managing property. When an investor uses the proceeds from a 1031 exchange to reinvest in real estate directly, they become an active investor.
For those seeking a truly passive investment, a DST may be a better option as it allows for passive ownership with the tax benefits of real estate investment, as well as the ability to better diversify one’s real estate holdings.
Potential Disadvantages Of Investing In A DST Compared To Direct Ownership
The potential disadvantages of DSTs are similar to those of direct ownership. As with all real estate investments, DSTs may also lose value, and their income stream can be impacted by tenant losses, which means it is not guaranteed.
While both DSTs and direct ownership are considered illiquid, one noticeable difference between DSTs is that they typically have a hold period of five to seven years. There is also no secondary market for DSTs, meaning you cannot sell your interests as easily as you could with a direct ownership property. DSTs are also professionally managed on behalf of investors, meaning that investors have no control on how these assets are managed.
The difference between active and passive investing is significant, and it’s important for investors to understand which approach aligns with their goals. If you prefer active management and real estate that can potentially be liquidated quickly, direct ownership may be the best fit for you. For those seeking a more hands-off investment, rolling the proceeds from the sale of a property into a DST through a 1031 exchange can be a favorable option as it allows them to defer capital gains tax and aim for passive income.
Not an offer to buy, nor a solicitation to sell securities. All investing involves risk of loss of some or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing. Any information provided is for informational purposes only.
Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.
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