Many people who own or would like to own investment real estate are exposed to a “DST”. It is entirely possible that they could be exposed to two differently described DST’s and wonder if they are one in the same, or one a variation of the other. In order to avoid confusion, they are entirely different. One, the Delaware Statutory Trust, is a form of passive ownership in real estate. The other, the Deferred Sales Trust, is a legal and tax strategy designed to allow owners of appreciated assets (including real estate, a business or other appreciated assets), to sell that asset and defer payment of capital gains.
Many people who own or would like to own investment real estate are exposed to a “DST”. It is entirely possible that they could be exposed to two differently described DST’s and wonder if they are one in the same, or one a variation of the other. In order to avoid confusion, they are entirely different. One, the Delaware Statutory Trust, is a form of passive ownership in real estate. The other, the Deferred Sales Trust, is a legal and tax strategy designed to allow owners of appreciated assets (including real estate, a business or other appreciated assets), to sell that asset and defer payment of capital gains.Many people own real estate for investment purposes. Such investments are often treated as “passive investments” for tax purposes, but for owners of individual real property assets, they are anything but passive. Property maintenance, tenant issues, repairs and refurbishments, and tenant turnover issues are all activities that require active attention and investment. It is not uncommon for such investors, especially in their retirement years, to start to feel handcuffed by their properties. They never want to stray too far away in case there is a need or requested repair or a tenant who is late with their rent, which requires their attention.
Some people, including baby boomers, who hold highly appreciated real estate assets, may be at a stage in their lives when they are seeking more passive investment opportunities. Passive (professionally managed) ownership may allow them to concentrate on other opportunities in life that they may have always been passionate about but never had the time to thoroughly enjoy.
It is at this intersection that the tale of the two DST’s appears. Both forms of DST can have appeal to investment property owners who wish trade in the “tenants, toilets and trash” in favor of the “clubs, cocktails and cruises”.
The Delaware Statutory Trust enables a real estate investor to maintain an investment position in real estate without the personal management responsibilities. The Deferred Sales Trust allows a real estate investor to sell a highly appreciated property and defer payment of capital gains. The investor can either reallocate the proceeds of the sale into a more liquid, diversified portfolio of securitized investments from which to draw income or continue to invest in more real estate or a business without having to conform to the rigid rules governing 1031 exchanges.
Both strategies have value and both have their pros and cons.
Enter the Delaware Statutory Trust
Passive Investment Benefits
Delaware Statutory Trusts are truly a passive way to own real estate. DST investors may benefit from a professionally managed, potentially institutional quality property. The underlying property could be a 500-unit apartment building, a 100,000 square-foot medical office property or a shopping center leased to investment-grade tenants. The possibilities are endless.
A Delaware DST may have up to 100 investors (sometimes more), with each investor owning a beneficial interest in the trust which, in turn, owns the underlying asset. The real estate sponsor firm, which also serves as the master tenant, simply acquires the property under the Delaware DST umbrella and opens up the trust for potential investors to purchase a beneficial interest. The investors may either deposit their 1031 exchange proceeds into the Delaware DST or the investor may purchase an interest in the Delaware DST directly. Another benefit for the individual investor is that, even though they may need to replace debt (such as through a 1031 exchange requirement) they are not required to individually qualify for the replacement debt in the Delaware DST. The sponsor/master tenant is the one responsible for the debt, or mortgage on the property.
Legality
In 2004, the IRS blessed Delaware DSTs with an official Revenue Ruling about how to structure a Delaware DST that will qualify as replacement property for 1031 Exchanges. The Revenue Ruling (Rev. Ruling 2004-86) permits the DST to own 100 percent of the fee-simple interest in the underlying real estate and may allow up to 100 investors — sometimes more — to participate as beneficial owners of the property.
Delaware DST’s Pose Risks
Delaware DSTs, like any investment, are not without risks. As with any type of real estate investment, investors may be subject to high vacancy rates and loan defaults. Also, Delaware DSTs are not sole-ownership investments. A DST is a more passive investment made up of multiple owners and ultimately controlled by the master tenant — the sponsor. This means that the individual investor is not in control of their investment. If they hope to maximize their investment, they may have to hold the Delaware DST investment for 7 to 10 years, or longer.
Economic Benefit During the Investment Period
Generally, the sponsor/master tenant will distribute net income to the ‘passive investors’ on a regular basis. The amount of your distribution or your “income rate of return” will vary based on several factors including the level of your pro rata mortgage debt, the rate of occupancy of the properties, the amount of investment in upgrades and repairs, and the sponsor/master tenant’s fees charged for the property management along with trust management fees and participation rate (or profit margin expected by the sponsor/master tenant). You will typically be quoted a range of expected income return on your investment in terms of the expected quarterly distributions to you. Depending on the above factors, your actual return may be better or worse than estimated and may vary from time to time.
Sound Reasonable? It could be. Sound expensive? Well, it can be. You see Delaware DST’s are like mutual funds, except they invest in real estate as opposed to stocks and bonds.
Distributing your final profits
Before any actual property management fees are expended, there are formation costs as well as marketing and distribution costs. These costs will be recouped by the sponsor/master tenant before any distribution of profit occurs. As to the marketing and distribution costs, most Delaware DST’s are offered through Registered Investment Advisors. Marketing costs are necessary to get their attention and then commissions are paid to advisors largely in sync with traditional realtor commissions. Once the Delaware DST offering is fully funded, the sponsor/master tenant will collect fees for both property management and the Delaware DST Trust administration.
It is not uncommon to see ongoing fees of between 6% and 15% of gross income deducted from the amount available for distribution to the individual investors. The sponsor/master tenant will then operate the properties for you until they deem that it is time to sell. At that time, they will recoup their initial start-up fees including marketing and distribution costs, and distribute the balance to the investors.
That is not to say that an individual investor cannot make money with a Delaware DST. Even after the expenses associated with forming and managing a Delaware DST, individual investors in many cases stand to earn between 6% and 15% annualized return. They just have to be willing to stay the course and wait for the sponsor/master tenant to decide when the time is right for the entire investment group to sell. Individually, you may generate an additional profit upon sale, suffer a loss, or get your original principal back. You should be aware that breaking even usually results in a net loss because of depreciation write-offs used during the holding period.
Also be aware that the greater number of investors, plus the larger number of shares, may or may not protect your investment. Careful scrutiny of the controlling partner/sponsor is advised. There are a lot of crooks in this business.
For example, if you actually read through many of the prospectus’ presented for individual Delaware DST’s, you will see that some or all of the properties acquired for your particular Delaware DST have been acquired from the individual principal sponsors of the trust themselves. You are not typically told of the profits they make by buying the properties first and then selling them to you as the individual partners of the DST. You do not even know if the properties were acquired at a competitive market value or if the purchase price was inflated to the Trust.
It is important for investors who may be considering the Delaware DST strategy to consult with an experienced investment professional and to obtain competent legal and tax advice. Upon thorough evaluation, the Delaware DST structure may be a viable investment alternative for qualified real estate investors. But only your tax adviser and a lawyer can tell you if it's right for you.
The main point is that there can be some real gems in a properly managed and administered Delaware DST and they certainly have their place within the alternative investment arena. At the same time, it is imperative to properly vet these opportunities with professionals who have the requisite knowledge and experience to advise you on the right opportunities to pursue.
Enter the Deferred Sales Trust 
If you are considering the sale of a business, corporation, or investment real estate, you may face capital gains taxes associated with the sale. For the investor who does not want to continue holding investment property or remain in the same business, a Deferred Sales Trust should be considered. According to section 453 of the Internal Revenue Code, the Deferred Sales Trust provides investors a solution whereby they can defer capital gains upon sale of their assets and redirect the sale proceeds into cash or whichever types of investments suit their needs, income requirements, and objectives.
What is a Deferred Sales Trust?
The Deferred Sales Trust is a legal contract between you and a third-party trust in which you sell real or personal property or a business to the Deferred Sales Trust in exchange for the Deferred Sales Trust's contractual promise to pay you a certain amount over a predetermined future period of time in the form of an installment sale note or promissory note. It is often referred to as a “self-directed note” because you have control over the terms of the note. The Deferred Sales Trust gives you the ability to control your capital gains tax exposure, reinvestment terms, and installment payments made from the trust.
How Does a Deferred Sales Trust Work?
The process begins when a property or business owner transfers his asset to a trust managed by a third-party company on his behalf. The third-party company acts as trustee over the asset, and the owner is the secured creditor of the trust that holds the asset. The trust will sell the asset to the owner’s buyer and manage and distribute the sale proceeds of the trust according to an agreed-upon installment contract that the owner sets up ahead of time with the trust.
The sales proceeds can be held in cash, reinvested, and distributed according to the direction of the owner's installment contract. There are zero taxes to the trust on the sale, since the trust purchases the property from the owner for the same price for which it is sold.
The tax code does not require payment of any of the capital gains taxes until an investor starts receiving installment payments that include principal. The owner is then able to control if, when, and how there will be capital gains tax exposure over the installment contract period by adjusting the installment contract.
The installment contract between the owner and the trust company provides flexible options on when and how payments can be made. Initially, the owner may have other income and may not need the installment payments right away, which would defer income and capital gains taxes. If an owner wants income but does not want to pay capital gains taxes, he/she can set up the installment contract to pay interest-only payments from the reinvested sales proceeds. According to IRC section 453, this strategy can defer the capital gains tax indefinitely.
Guidelines for the Deferred Sales Trust to Qualify as Permissible Trust Structure:
In order for a Deferred Sales Trust to qualify for capital gains tax deferral, it must be considered a bona fide third-party trust with a legitimate third-party trustee.
Independent Trustee: The Deferred Sales Trust must employ a trustee that is truly independent of the owner/beneficiary of the trust. If there is not real trustee independence from the owner then the IRS considers this to be a sham trust, set up for the sole purpose of creating layers of legal documents to avoid taxation. The independent trustee is responsible for managing the trust according to the laws that govern trusts, the installment contract, and the investor's risk tolerance and investment objectives.
Asset Transfer: In order for the Deferred Sales Trust to shield the owner from capital gains taxes, the owner must not take constructive receipt of any sale proceeds from the disposition of an asset. The trust, which is created on behalf of the investor, must take legal title to sale proceeds directly from the disposition of an asset or from a third-party qualified intermediary that is holding the sale proceeds on behalf of the investor in order to qualify for capital gains tax deferral.
Asset Ownership: Asset ownership must be legitimately transferred to the trust prior to a sale for the sale proceeds to be sheltered from capital gains tax. If the owner did not transfer practical ownership over to the trust and still retains all of the benefits of direct ownership, the IRS disallows the owner from enjoying the tax-advantaged benefits afforded by the trust's ownership. In other words, the property must be legitimately transferred to the trust or it will be taxed as if it were not.
Assets Must Remain in Estate: The owner cannot use the trust to transfer any economic interest to a third party without due compensation. The IRS does not allow this type of transaction because it allows people to pass assets out of their estate without bearing capital gains, gift, income, or estate taxes.
Failed Exchange Rescue
One of the most unique benefits of the Deferred Sales Trust is its ability to rescue an investor from capital gains taxes in the event of failed 1031 or 721 exchanges. In the case of a 1031 or 721 transaction, the investor's sale proceeds from the disposition of an asset go to a qualified intermediary (QI). The QI holds these proceeds on behalf of the investor in order to close on a replacement property to complete the investor's tax-deferred exchange. Should the exchange fail, whereby the funds cannot be reinvested into a property according to IRS guidelines, the funds held at the QI are subject to capital gains and depreciation recapture taxes once released from the QI to the investor.
The Deferred Sales Trust provides a ready solution to this problem by allowing the funds to revert to a trust rather than to the investor. The investor is saved from taking constructive receipt of the funds and bearing the capital gains and depreciation recapture taxes. The investor can tailor his investment contract with the trustee to pay him his funds in a manner that will effectively defer taxes over the installment contract.
Other Considerations – Depreciation Shelter:
Some types of depreciation recapture may be deferred, but any excess accelerated depreciation over the straight line depreciation method cannot be deferred. Fees for setting up a deferred sales trust may be higher than those of a 1031 exchange.
Trust Legitimacy:
If a deferred sales trust is improperly managed and the IRS chooses to investigate, it is possible that the trust could be designated as a “sham trust.” If a trust is labeled a sham by the IRS, the income from the initial sale is taxed as though the trust did not exist. Therefore, it is very important that Deferred Sales Trusts are established and operated according to IRS guidelines and trust law. The use of qualified and experienced professionals is therefore highly recommended. Fortunately, Campbell Law, our tax law firm and the architect of the proprietary strategy known as the Deferred Sales Trust has successfully closed hundreds of millions of dollars in DST transactions over the past 21 years; cleared 14 separate audits and a formal review with the IRS without a single adverse finding.
The applicable tax codes apply and relate to federal law only. Individual states may have their own additional tax codes. Please contact the appropriate tax and legal professional in your state. This information is provided from sources believed to be reliable but should be used in conjunction with professional advice that is consistent with your personal situation.
For more information and to speak to a DST Specialist Call (800) 235-0963
