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Investors Should Do Their Homework when Considering a 1031 DST Exchange

by | Nov 1, 2022 | Commercial Real Estate, Real Estate

How does a 1031 DST Exchange work?

One of the key benefits of a Delaware Statutory Trust (DST) is the flexibility it gives commercial real estate investors who are racing against the clock to complete a 1031 exchange before they hit the deadlines for identifying and closing on the sale of a replacement property.

Yet speed should not mean stinting on due diligence when it comes to making an investment via a 1031 DST exchange. Investors, working with their trusted financial and legal advisers, should carefully review the DST offering, terms, and sponsor before going ahead with an investment. 

Under 1031 exchange rules, investors may defer capital gains taxes on profits from the sale of a property if they invest in a similar (or “like-kind”) property. Investors must act quickly, however: They have 45 days to identify like-kind real estate, and 180 days to close on the sale. 

In a tight real estate market, the inventory of suitable properties may be low, which can make meeting 1031 exchange deadlines a significant challenge. A DST can provide a greater variety of options over other 1031 exchange alternatives, because a DST allows investors to buy a fractional interest in commercial real estate assets that qualify as replacement properties. 

Commercial real estate investors also have the option of investing in 1031 DST sidecars (or “co-investments”), which allow them to invest alongside larger investors and share in the potential upside of their real estate investment strategies. The constricted timeline of a 1031 exchange is another reason sidecars can be an attractive option for an investor. The properties involved usually will have been vetted by professional asset managers, thus giving investors additional confidence in their potential returns.

Less Control over Assets

The DST process does require investors to give up a significant measure of direct control over assets. The federal tax code prohibits investors from actively managing a DST property. Management falls to the trust itself, which usually turns over day-to-day responsibilities to a master leaseholder. In a DST sidecar arrangement, the investor also turns over the decision-making authority about which properties should be the subject of an investment.

For many investors, the passive nature of a 1031 DST exchange is a plus. They may no longer wish to shoulder property management burdens, and fractional investments made by the DST may give them access to higher-value real estate than they might otherwise have been able to afford.

Still, investors should carefully consider if a DST is right for them. A long-time commercial property owner who is accustomed to hands-on management may bridle at a passive investment arrangement. Those seeking significant liquidity may also wish to steer clear as a DST—like any traditional real estate purchase—usually has a multi-year hold time. Investors should also closely examine the real estate assets being purchased by the DST. They might ask: What type of property is being acquired? Where is the property located? What are the anticipated annual returns? How will issues such as taxes or property appreciation affect expected returns? Even in a sidecar arrangement, a potential investor should have a clear understanding of the properties that are part of the underlying investment, notwithstanding the role of investment professionals in selecting those assets.

Assessing the Sponsor

Also critically important is evaluating the qualifications and track record of the DST sponsor. In the context of a Delaware Statutory Trust, a sponsor (sometimes referred to as the trustee) is the person or company that has created the trust and that manages the investment through its entire lifespan.  A sponsor makes the investment available to accredited investors, including those executing on a 1031 exchange, and organizes potential sidecars for ride-along investors. 

Sponsors traditionally locate and negotiate leases with master tenants, who often take on the day-to-day management of properties, including handling repairs and subleasing to other tenants. The sponsor is also responsible for financial reporting, taxes and for distributing returns to investors. Among the factors that investors might consider when evaluating a sponsor are:

  • Experience. How much commercial real estate investment management experience does the sponsor have? Does it have a long track record of performance? How has it performed during tough economic times? 
  • Management. Does the sponsor have a management team with the necessary experience and resources to properly analyze the performance of investments and to communicate regularly with investors about them?
  • Competency. Does the sponsor have sufficient knowledge of the specific type or class of property in question? Does it have expertise in a particular geographic location? Does it have the knowledge and contacts to effectively market a DST? 

To help reduce risk, investors should strongly consider consulting with a trusted legal adviser to help them with due diligence and navigating the 1031 DST exchange process. To learn more about 1031 DST exchanges, sidecars, and how we can help, contact us for a consultation.