Six Risks of Delaware Statutory Trusts in 1031 Exchanges

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Imagine you're playing a high-stakes game of Monopoly, but instead of rolling dice and moving plastic pieces, you're dealing with real estate investments and tax deferrals. Welcome to the world of Delaware statutory trusts (DSTs) in 1031 exchanges.

Regular readers of this space will know that we already view a 1031 exchange into a DST as a powerful tool for building tax-deferred wealth, and we spend a lot of time talking about the pros.

But while these investment vehicles can be powerful tools for real estate investors, they're not without their cons. A good real estate investor will understand both the pros and cons of DSTs before jumping into the deep end of the pool.

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So, let's dive into the potential risks and challenges, complete with real-world examples to help you navigate this complex landscape.

DSTs have become increasingly popular among real estate investors looking to defer capital gains taxes through 1031 exchanges. They offer enticing benefits like passive income, professional management and the ability to invest in institutional-grade properties.

However, like the mythical sirens luring sailors with their enchanting songs, DSTs have risks that investors must be aware of before taking the plunge.

Risk No. 1: No guarantees in the real estate game

Just as a star quarterback can't guarantee a Super Bowl win, DSTs can't promise foolproof returns. The real estate market is as unpredictable as a game of chance, subject to economic fluctuations, fickle tenants and unforeseen challenges.

Example: In 2008, many DST investors learned this lesson the hard way when the real estate market crashed. Properties that seemed like sure bets suddenly lost significant value, leaving investors with diminished returns and, in some cases, substantial losses.

On the other hand, any form of investment is accompanied by a risk of loss; experienced investors, including those who primarily invest in real estate, know to diversify their investments to minimize this risk. A generational event like the 2008 crash took no prisoners, to be clear, but stock and bond investors can also attest to significant losses during that time. No one’s investment plan should be based on the fears of a once-in-a-decade crisis.

Risk No. 2: Backseat driving in your investment

Investing in a DST is like being a passenger in a car — you're along for the ride, but you're not behind the wheel. As an investor, you don't hold the title to the property; instead, you own "beneficial interests" in the trust. The sponsor controls the property's management and sale, which can be frustrating for hands-on investors accustomed to calling the shots.

Example: Let's say you're part of a DST that owns a shopping center. You notice the anchor tenant's business is struggling and believe it's time to find a replacement. However, as a DST investor, you can't make that decision — you're at the mercy of the sponsor's judgment, for better or worse.

On the other hand, your financial team, if they’re doing their job, will research your sponsor to make certain that you’re hitching your wagon to a star that has experience through good markets and bad. As before, nothing comes with guarantees, but just as an investment in a blue-chip stock will present far less risk than a penny stock, so too the choice of an experienced, knowledgeable DST sponsor will increase your odds for success.

Risk No. 3: Trapped in an investment time capsule

Investing in a DST is like putting your money in a time capsule — it's not easy to retrieve before the designated time. DST interests are notoriously illiquid, with no active secondary market for selling your stake. This lack of flexibility can be problematic if you suddenly need access to your capital.

Example: Imagine investing $500,000 in a DST with a projected seven- to 10-year holding period. Two years in, you face an unexpected medical emergency requiring significant funds. Unfortunately, your DST investment is essentially locked up, leaving you in a financial bind.

On the other hand, a savvy financial team will not allow you to lock up your last available investment dollar in an illiquid investment. As with any investment, step one is to make certain you have a sufficient emergency fund in a liquid account so that life’s emergencies (and they will happen) do not present you with insurmountable obstacles.

Risk No. 4: Death by a thousand paper cuts (or fees)

While DSTs can offer attractive returns, they often come with a smorgasbord of fees that can eat into your profits. These may include acquisition fees, asset management fees, disposition fees and more. It's crucial to weigh these costs against your potential tax savings.

Example: Let's say you invest in a DST that projects an 8% annual return. However, after accounting for various fees totaling 2% annually, your actual return drops to 6%. Over a 10-year investment period, this 2% difference could amount to tens of thousands of dollars in lost profits.

On the other hand, the right financial team (are you sensing a theme here?) will be able to assist you in analyzing all aspects of a potential deal, including (and perhaps especially) the cost structure. Every DST sponsor is in the business to make money, of course, and reasonable fees are part of the package; still, you’re looking to improve your bottom line, not the sponsor’s.

Risk No. 5: The taxman cometh (maybe)

DSTs are structured based on IRS Revenue Ruling 2004-86, which allows DSTs to qualify for 1031 exchanges. However, the IRS could theoretically change its stance or rule unfavorably on a specific DST offering, potentially resulting in unexpected tax liabilities.

Example: Imagine you invest in a DST, deferring $200,000 in capital gains taxes. Five years later, the IRS issues a new ruling that disqualifies your specific DST structure from 1031 exchange eligibility. Suddenly, you're on the hook for that $200,000 tax bill, plus interest and penalties.

On the other hand — yep, it’s another reason to make sure you have the right people on your team, to make sure the odds of any potential deal collapsing are slim to none. A properly structured DST should fit well under the auspices of current IRS rules, and your team is there to make sure there are no unpleasant surprises.

Risk No. 6: The 'seven deadly sins' of DSTs

To maintain their tax-advantaged status, DSTs must adhere to seven strict rules, often called the "seven deadly sins." These restrictions limit the trust's ability to adapt to changing market conditions, potentially impacting performance.

Example: Your DST owns an office building with a major tenant whose lease is expiring. Due to the "seven deadly sins," the DST can't renegotiate the lease terms or secure a new tenant without risking its tax status. This inflexibility could lead to a significant vacancy and lost income.

On the other hand, the quality of tenants and the length of lease terms should be known to you before you enter the DST. No investment is risk-free, of course, and this is certainly true of DSTs, but a properly structured DST is put together with the knowledge that the structure is illiquid by design and with the expectation that it will prosper in the years that follow.

Conclusion: Knowledge is power

While these risks may seem daunting, they shouldn't necessarily scare you away from DST investments. Like any investment strategy, DSTs have their pros and cons. The key is to approach them with eyes wide open, armed with knowledge and realistic expectations.

Before diving into a DST investment, consult with experienced professionals who can help you navigate the complexities and determine if it's the right move for your financial goals. Remember, in the world of real estate investment, fortune favors the prepared.

Disclaimer

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

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Daniel Goodwin is a Kiplinger contributor on various financial planning topics and has also been featured in U.S. News and World Report, FOX 26 News, Business Management Daily and BankRate Inc. He is the author of the book "Live Smart - Retire Rich" and is the Masterclass Instructor of a 1031 DST Masterclass at www.Provident1031.com. Daniel regularly gives back to his community by serving as a mentor at the Sam Houston State University College of Business. He is the Chief Investment Strategist at Provident Wealth Advisors, a Registered Investment Advisory firm in The Woodlands, Texas. Daniel's professional licenses include Series 65, 6, 63 and 22. Daniel’s gift is making the complex simple and encouraging families to take actionable steps today to pursue their financial goals of tomorrow.