Delaware Statutory Trusts and 1031 Exchanges: Tax Rules for Real Estate Investors
A Delaware statutory trust can provide real estate investors with a way to acquire a fractional interest in institutional real estate without directly managing the property.
Certain DST interests can also qualify as replacement property in a Section 1031 exchange. That treatment is based primarily on Revenue Ruling 2004 86, which concluded that owners of the qualifying trust described in the ruling were treated for federal income tax purposes as owning proportionate interests in the underlying real estate.
The ruling does not mean that every entity labeled a Delaware statutory trust automatically qualifies for Section 1031.
Key Tax Takeaways
- Certain DST interests can qualify as replacement real property for Section 1031 purposes.
- Revenue Ruling 2004 86 is the principal federal authority supporting this treatment.
- The ruling depends on the DST being classified as an investment trust rather than a partnership or business entity.
- Owners are treated for federal income tax purposes as owning proportionate interests in the underlying trust property.
- The trustee's powers must be restricted so the trustee cannot materially vary the investment.
- Restrictions can limit refinancing, new leasing, new capital contributions, property exchanges, and major modifications.
- A DST can satisfy a 1031 replacement property need when the investor does not want direct management responsibility.
- DST debt can affect the Section 1031 liability and boot calculation.
- The investor generally receives a share of income, deductions, depreciation, and tax attributes of the underlying property.
- A DST does not eliminate passive activity loss limitations.
- DST interests are illiquid investments and tax qualification should be evaluated separately from investment quality.
What Is a Delaware Statutory Trust?
A Delaware statutory trust is a legal trust created under Delaware law.
In the real estate context, a sponsor can place one or more properties into a DST and sell beneficial interests to investors.
Investors generally do not personally manage the day to day real estate operations. The trustee, sponsor, master tenant, property manager, or other parties handle the applicable operational responsibilities under the offering structure.
Why Can a DST Qualify for Section 1031?
Section 1031 currently applies to qualifying real property.
A normal partnership interest does not qualify merely because the partnership owns real estate.
Revenue Ruling 2004 86 reached a different result for the DST described in that ruling because the trust was classified as an investment trust and each owner was treated as owning a proportionate share of the underlying trust assets for federal income tax purposes.
The IRS therefore treated the exchange into the DST interest as an exchange into an undivided interest in the underlying rental real estate.
Not Every DST Automatically Qualifies
The trust agreement, trustee powers, property structure, leasing arrangement, financing, and other facts must be consistent with federal tax requirements. The name placed on the entity does not determine Section 1031 qualification.
Why Are DST Trustee Powers Restricted?
Revenue Ruling 2004 86 relied heavily on the fact that the trustee did not have a power to vary the investment of the beneficial owners.
The trustee's activities were largely limited to collecting and distributing income and performing ministerial functions.
Under the ruling, the trustee could not generally:
- Exchange the real property for another property
- Purchase additional assets other than limited short duration investments for cash reserves
- Accept additional capital contributions
- Renegotiate the acquisition debt
- Renegotiate the lease or enter into new leases except in limited circumstances involving tenant bankruptcy or insolvency
- Make more than minor nonstructural modifications unless required by law
- Invest cash in a manner designed to profit from market fluctuations
Why Can Those Restrictions Become an Investment Risk?
The same limitations supporting the desired federal tax classification can reduce operational flexibility.
If market conditions change, financing matures, a tenant fails, or substantial capital work is needed, the trustee may have less flexibility than an ordinary partnership manager.
Tax Qualification and Investment Quality Are Different Questions
A DST can satisfy a Section 1031 replacement property objective and still be a poor investment. Property quality, tenant strength, leverage, fees, sponsor experience, projected cash flow, financing maturity, reserves, and exit strategy require separate investment analysis.
How Does a DST Fit Into a 1031 Exchange?
A taxpayer can identify a qualifying DST beneficial interest as replacement property in a deferred exchange.
The normal 45 day identification and 180 day exchange period rules still apply.
The DST therefore does not provide extra time merely because it is a fractional replacement property.
See 1031 Exchange Rules for Real Estate Investors .
Why Do Investors Use DSTs as Replacement Property?
Potential reasons include:
- The investor does not want direct property management responsibility.
- The investor needs replacement property quickly within the 45 day identification period.
- The investor wants fractional ownership of larger institutional real estate.
- The investor wants to allocate exchange proceeds among several replacement properties.
- The investor wants a more passive real estate ownership structure.
How Does DST Debt Affect the Exchange?
Many DST properties are financed with nonrecourse mortgage debt.
The investor's proportionate share of applicable debt must be incorporated into the Section 1031 exchange calculation.
Debt relief on the relinquished property can create taxable boot when it is not sufficiently offset by liabilities associated with replacement property or additional cash invested.
Do Not Use a Simple Debt Replacement Rule
There is no separate federal requirement stating that replacement mortgage debt must always equal or exceed relinquished property debt. Liabilities, cash invested, cash received, and replacement property value must be analyzed together under the Section 1031 rules.
Can I Split a 1031 Exchange Between a DST and Direct Real Estate?
Potentially, yes.
An investor can acquire more than one qualifying replacement property, subject to the identification rules.
For example, an investor might acquire one directly owned rental property and use remaining exchange proceeds to acquire a qualifying DST interest.
How Is DST Income Taxed?
In the structure addressed by Revenue Ruling 2004 86, the beneficial owners are treated as owners of proportionate shares of the trust assets.
Income, deductions, and credits attributable to each owner's proportionate share are therefore taken into account by that owner.
A properly structured DST generally is not taxed as a partnership merely because several investors hold beneficial interests.
Investors commonly receive annual tax information reflecting their share of rental income, expenses, interest, and depreciation rather than a partnership Schedule K1, although the particular reporting package should be reviewed for the specific investment.
Can a DST Generate Passive Losses?
Yes.
The federal trust classification does not eliminate Section 469.
Rental real estate income and losses attributable to the investor can generally be passive unless an applicable exception applies.
A passive DST loss may therefore be suspended when the investor does not have sufficient passive income.
Does Real Estate Professional Status Make a DST Nonpassive?
Not automatically.
A real estate professional still must satisfy the applicable material participation requirements for the rental real estate activity.
A highly passive DST investment can make material participation difficult as a factual matter, even if the investor qualifies as a real estate professional through other real property businesses.
How Does Depreciation Work?
Because investors are treated as owning their proportionate shares of the underlying property in the qualifying grantor trust structure, depreciation deductions attributable to that share generally flow to the investor.
Basis from a Section 1031 exchange can include carryover basis and additional investment basis, so the tax depreciation available to one investor can differ from another investor's economic purchase price.
What Happens When the DST Property Is Sold?
A future property disposition can recognize the deferred gain that was preserved through the investor's basis.
The transaction can also generate Section 1231 gain, depreciation recapture, unrecaptured Section 1250 gain, and passive activity consequences.
The investor can potentially consider another Section 1031 exchange if the transaction and replacement property satisfy the applicable requirements.
Can a DST Interest Be Easily Sold Before the Property Is Sold?
DST interests generally should be viewed as illiquid investments.
There may not be a readily available secondary market, and the offering documents can impose transfer restrictions.
An investor should therefore evaluate expected holding period and liquidity needs before using a DST merely to meet an exchange deadline.
What Should Be Reviewed Before Investing in a DST?
- Section 1031 qualification
- Revenue Ruling 2004 86 structure
- Property type and location
- Purchase price and valuation
- Tenant concentration
- Lease terms
- Property debt
- Interest rate and maturity
- Investor's proportionate debt allocation
- Sponsor and management fees
- Cash reserves
- Projected holding period
- Exit provisions
- Expected depreciation
- Passive activity loss treatment
- State income tax exposure
Tax Review Is Not Investment Due Diligence
Determining that an interest can qualify for Section 1031 does not establish that the investment is suitable, fairly priced, appropriately leveraged, or likely to achieve the sponsor's projected returns.
California Investors Need Additional Analysis
A California source gain deferred through Section 1031 can remain subject to California sourcing and reporting rules after the investor acquires replacement property outside California or moves to another state.
A DST does not eliminate those California tracing rules.
See California 1031 Exchanges and Deferred Gain .
Frequently Asked Questions
Can a Delaware statutory trust qualify for a 1031 exchange?
Certain DST interests structured consistently with Revenue Ruling 2004 86 can qualify as an interest in real property for Section 1031 purposes.
Does every DST qualify?
No. Federal tax classification depends on the specific trust agreement, trustee powers, and other facts.
Why can the DST trustee not freely refinance or improve the property?
Restrictions on the trustee's ability to vary the investment are central to the investment trust treatment described in Revenue Ruling 2004 86.
Do DST investors receive a partnership K1?
A qualifying grantor trust structure generally is not treated as a partnership. Investors commonly receive tax reporting information reflecting their proportionate share of trust activity rather than a partnership K1.
Can a DST create passive losses?
Yes. Section 469 continues to apply to the investor's rental real estate activity.
Can I use a DST to complete part of my exchange?
Potentially, yes. A qualifying DST can be one of multiple replacement properties when all identification and exchange requirements are satisfied.
Review the Tax Structure Before Using a DST in a 1031 Exchange
I assist real estate investors with DST tax analysis, Section 1031 basis calculations, debt, boot, passive activity treatment, depreciation, California deferred gain, and the federal tax consequences of eventual disposition.
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