Delaware Statutory Trusts (DSTs) are passive investment options that can be used as replacement properties for a 1031 exchange. They’re often attractive to investors who want to maintain exposure to real property while also avoiding the hassles that can come with direct property ownership.
These entities hold the title to one or more investment properties and allow investors to purchase undivided fractional shares, also known as beneficial interests. The DST sponsor vets and acquires each property and is responsible for all decision-making, maintenance, financial accounting, and reporting.
Many DSTs use leverage to purchase the underlying properties and have debt built into their structures. This can be beneficial for investors who need to replace existing mortgage debt to meet the 1031 exchange debt replacement rule. However, some investors may prefer debt-free, all-cash DSTs as a way to potentially minimize the risks that can be created by taking on debt.
All-cash DSTs differentiate themselves by only holding properties that are unencumbered by any type of mortgage or loan. While this option may not be right for everyone, there are some potential advantages to consider. Here’s a look at five reasons why debt-free DSTs are a trend that is likely here to stay.
Leveraged DSTs must make required debt payments in full every month before distributing funds to investors. During times of economic volatility, property revenues may decrease, potentially lowering the amount of income available for distribution after debt payments are made.
All cash DSTs have no debt service requirements. This may reduce the risk of distribution reductions and potentially create a more stable cash flow, provided that the underlying asset continues to perform.
There are many different types of DSTs to choose from, offering additional opportunities for diversification. For example, you may select a combination of DSTs that invest in different types of properties and across various geographic locations. Further diversification can also be achieved by selecting a mix of both leveraged and non-leveraged DSTs.
The impact of the COVID-19 pandemic has made it clear that in extreme circumstances the risk of foreclosure on DST-held properties is a realistic possibility. Investors do have some protection since DST debt is nonrecourse debt. This means that lenders cannot go after investors for debt payments and defaults on DST debt do not impact individual investors’ credit scores. However, if property income is not sufficient to meet debt-service payments, the lender can foreclose on the property, which could result in a loss of your investment principal.
Since a debt-free DST owns all properties free and clear, there’s no risk of losing the property in a foreclosure due to non-payment of the debt.
The loans of leveraged DSTs generally must be repaid in five to ten years. Since DSTs cannot be refinanced, DST Sponsors must sell leveraged DSTs prior to the due date of the loan, which may result in sub-optimal returns if the DST is sold during an economic downturn. Provided that the underlying asset continues to perform well, a debt-free DST can be held until market conditions improve.
When a DST runs full-cycle, investors who wish to continue deferring their capital gains taxes and depreciation recapture must follow IRS rules to successfully complete a 1031 exchange. To receive full tax deferral, 1031 exchange rules require investors to choose a replacement property that is of equal or greater value as the relinquished property. This includes replacing any mortgage debt that was held on the relinquished property.
Choosing a debt-free DST can help you avoid having to take on additional debt during a future 1031 exchange. Some investors appreciate this additional flexibility.
In times of economic turbulence and market volatility, investing in an all-cash DST may potentially reduce exposure to risk by allowing you to hold real property in your portfolio without taking on additional debt. Investors who want to remain debt-free and/or take a conservative position with their property holdings may find this option attractive.
It’s important to note that if you currently have a DST or property investment that has a debt component and you’re planning to complete a 1031 exchange, debt replacement requirements typically apply. Consulting with a financial professional prior to choosing a replacement property can help ensure that you meet all IRS requirements for a full 1031 exchange. To learn more about DSTs that may be appropriate for your needs, contact us to schedule a consultation with our team.