How to Use a 1031 Exchange to Acquire Delaware Statutory Trusts

Property investors have different capabilities and goals throughout their careers. While they may own a house or multi-family unit for several years (or even decades), a time comes when they need to sell those assets and adjust their portfolios.

Investors have multiple options for selling property, along with tax deferral strategies to save money. Under the Internal Revenue Code, specifically Section 1031, they can defer capital gains taxes by participating in exchanges that allow them to reinvest the proceeds from a relinquished property into another qualifying investment, such as a Delaware Statutory Trust (DST), rather than simply cashing out and paying taxes on the profits.

One option is to complete a 1031 exchange to Delaware Statutory Trust (DST). Learn more about this concept and how it can help you defer taxes while reinvesting your money.

What is a 1031 Exchange?

When you sell an asset, you need to pay capital gains tax on the profits. However, IRC Section 1031 in the federal tax code allows investors to defer their taxes if they reinvest the net proceeds from the sale of an investment property into a new, like-kind property within 180 days as part of a qualifying like-kind exchange. This does not mean that real estate investors can sell their properties and then buy stocks or bonds, but rather that they can identify replacement property and purchase it when it falls within a similar market value.

The IRS is also clear that a 1031 exchange is not a tax abatement, but rather a deferral. The seller will still need to pay capital gains tax when they liquidate their investment, but they will not need to pay taxes immediately if they are exchanging one property for another.

1031 Exchange Guidelines

There are a few important guidelines to follow for a 1031 exchange. First, the replacement assets must be identified within 45 days of selling the relinquished property. There is also a 180-day deadline to close on those investment opportunities. The process requires using a Qualified Intermediary (QI) to move sale proceeds into the DST within 180 days.

For example, if someone sells an investment property in one neighborhood, they have 45 days to find another house to buy and 180 days to close on that house (completing the inspection, appraisal, and due diligence processes while the buyer moves and plans their move-out and possession timeline after closing). These exchanges are also limited to business investments and cannot be applied to primary residences or second homes treated as investment properties.

To execute a 1031 exchange, a qualified intermediary must be engaged to facilitate the transaction and hold the proceeds from the sale of the relinquished property. Many investors hire a qualified intermediary to navigate the 1031 exchange process, ensuring they meet the right qualifications to avoid paying capital gains taxes that year.

What is a Delaware Statutory Trust?

A Delaware Statutory Trust (DST) structure allows multiple investors to hold fractional DST interests in DST property, with the DST sponsor responsible for identifying, acquiring, and managing the institutional grade properties within the trust. This setup enables investors to participate in large-scale, high-quality real estate assets that are typically out of reach for individuals, while the DST sponsor oversees property operations and facilitates the investment process.

One key part of the DST investment structure is that investors hold partial ownership through DST interests, rather than owning or managing the DST property directly. The passive nature of DST investments appeals to those seeking income-producing, professionally managed assets without the burdens of active property management. DSTs provide investors access to institutional grade properties, such as industrial, office, or multi-family assets, that would otherwise be too expensive or complex to acquire alone.

Requirements of a DST

Delaware Statutory Trusts usually have a minimum investment of $100,000, and real estate holdings usually last between three and 10 years. Investors gain fractional ownership in large, high-quality properties that are often too expensive to buy alone, and DSTs are typically private placements limited to accredited investors. People who want to purchase DSTs must be accredited investors. This means they meet at least one of the following criteria:

• People with a net worth over $1 million, excluding their primary residence.
• Income over $200,000 (individually) or $300,000 (with spouse or partner) for the past two years. The SEC requires an average annual income exceeding $200,000 for individuals or $300,000 for couples.
• Investment professionals in good standing with the SEC.
• Entities owning investments of more than $5 million.

When a DST is sold, investors receive their part of the proceeds and any gains from appreciation. They can then complete another 1031 Exchange to defer taxes or keep the profits liquid and pay taxes on them.

The Seven Deadly Sins of Delaware Statutory Trusts

DSTs come with a set of rules that investors must follow, known as the “Seven Deadly Sins.” These rules are based on IRS Revenue Ruling 2004-86 and current IRS rules, which establish strict operational guidelines for DSTs to ensure they qualify for a 1031 exchange by maintaining their status as passive, grantor trusts.

The Seven Deadly Sins actually refers to IRS Bulletin 2004-33, which outlines these operational rules.

Here is a breakdown of each rule of the Seven Deadly Sins:

1. There are no future equity contributions after closing. Once an investor has bought into a DST, they cannot make additional capital contributions to the trust after the initial offering closes. This prohibition helps maintain compliance with IRS Revenue Ruling 2004-86 and protects the ownership interests of all investors.
2. The DST trustee cannot renegotiate the terms of the loans or borrow new funds. This prevents sponsors from assuming more debt or acting in ways that negatively impact the investments of beneficiaries.
3. The trustee can not reinvest proceeds from the sale in more real estate. Essentially, the sponsor does not own the asset and must distribute any sales proceeds to beneficiaries. Investors can either complete another 1031 Exchange after a sale or keep the profits (after taxes).
4. The trustee is only allowed to make limited capital expenditures for repairs and maintenance. Major renovations, structural improvements, or upgrades are not permitted, as only minor repairs and non-structural improvements are allowed to protect the passive nature of the investment.
5. Any liquid cash can only be invested in short-term loan obligations. Cash is often kept in reserve to cover minor repairs. These funds can only be allocated to short-term loans that can be liquidated easily if the beneficiaries need to be paid out.
6. Liquid cash must be distributed to co-investors. Anything that isn’t saved to cover repairs must be given to the beneficiaries.
7. Trustees cannot enter into new leases or change the lease structure. This prevents the sponsor from changing the structure after each party has agreed to it.

These operational restrictions, while designed to protect investors and maintain compliance with IRS Revenue Ruling 2004-86, can limit a DST’s ability to adapt to changing market conditions, potentially impacting performance. Additionally, if the IRS changes its stance on DSTs or current IRS rules, investors could face unexpected tax liabilities on previously deferred capital gains.

Using a DST as Replacement Property in a 1031 Exchange

Delaware Statutory Trusts (DSTs) qualify as replacement properties in 1031 exchanges and offer passive ownership, allowing investors to defer capital gains taxes through 1031 exchanges. This is an option for people who no longer want to manage physical assets but still want to keep real estate investments in their portfolios. They opt for fractional ownership through DST investment and trust that a sponsor is acting in their best interest while managing the DST property.

When an investor sells a property, they take the liquid proceeds and purchase ownership in a DST. If the purchase is made within the 180-day window (and identified within 45 days of the original asset sale), then it can qualify for a 1031 exchange. DSTs can typically close within 3 to 5 business days after the sale of a relinquished property, significantly reducing the risk of missing the 180-day deadline for a 1031 exchange.

Real estate investors can purchase ownership of multiple DST properties. This allows them to diversify their portfolios while avoiding the tax liability of liquid profits.

For example, if a property owner sells a house and generates $400,000 in profits, they might invest in four DSTs. These purchases qualify as replacement property, and their capital gains taxes would be deferred.

Key Benefits of Delaware Statutory Trusts

Real estate investors are increasingly turning to DSTs because they are compatible with 1031 exchanges. There are several benefits of pivoting your real estate investment portfolio into this fractional ownership model. Here are a few pros to consider.

• No more property maintenance tasks. DST investors don’t have to handle repairs, upgrades, and tenant relations.
• Defer capital gains taxes and enjoy significant tax benefits. DSTs offer the ability to defer taxes through a 1031 exchange and can also provide potential valuation discounts of 20-30% for estate tax purposes, reducing the overall taxable value of your estate.
• Enjoy passive investment and monthly income. DSTs provide a truly passive investment experience, offering a monthly income stream—often through long-term triple net leased (NNN) properties—without the burdens of active property management. This is especially appealing for those transitioning into retirement.
• Diversify your portfolio. You can buy into multiple DSTs and choose different assets, property types, and geographic locations.
• Close faster on your investment. You don’t have to find a physical replacement property in your area.
• Gain access to large commercial investments. You could have a partial stake in multi-million dollar properties.
• Streamline estate planning. Beneficiaries who inherit a DST interest receive a step-up in basis, eliminating capital gains and depreciation recapture tax liability on the inherent gains during the original owner’s lifetime. Additionally, investing in a DST allows for potential valuation discounts for estate tax purposes.

You also don’t need to live in Delaware or purchase assets in Delaware to participate in a DST. This is a national real estate investment option.

Disadvantages of Delaware Statutory Trusts

Every investment comes with potential risks and drawbacks, and DSTs are no different. Here are a few things to be aware of before you start contacting potential real estate investors.

• The assets aren’t liquid. You may benefit from keeping liquid cash in your accounts or looking for options where you could divest in uncertain markets. Paying taxes in the short run could be worth stability in the long-run.
• Appreciation isn’t guaranteed. There is no promise that real estate investments will increase in value. You might break even at best on the asset.
• Real estate assets come with physical risks. Fires, storm damage, or vandalism could all still affect your investment and hurt potential profits.
• There is a higher barrier to entry. Not everyone has $100,000 to invest and is considered an accredited investor.
• There may be unwanted fees and costs. Before taking a beneficial interest in a property, investors need a clear understanding of the terms and costs associated with the purchase. Buying into a DST might cost more than you expect.

All of these reasons highlight the benefits of working with a trusted financial advisor or professional who has experience with Delaware Statutory Trusts. They can walk you through the costs and limits before confirming this is the right call for your investment strategy.

Due Diligence Checklist For A DST Offering

Just like any other investment, buyers need to conduct their due diligence on a DST offering before they take a beneficial interest in the property. Here are a few ways to evaluate whether an opportunity is sound and if the potential tax savings and passive cash flow are worth the risk.

• Evaluate the sponsor’s track record. Confirm that the sponsor has experience with DSTs and has active management in these properties already. Be sure to review their asset management capabilities, as effective asset management is crucial for maintaining property performance and value. This can avoid the sponsor making “rookie mistakes” that could cost you.
• Conduct a portfolio analysis. Review the tenants, the condition of the building, and the potential risks. Analyzing the investment structure and the characteristics of the real estate asset—such as whether it is institutional-grade or suitable for accredited investors—is crucial. Evaluating the property is just as important for a DST as a replacement building for your 1031 exchange.
• Carefully read legal documents. Make sure you understand everything before you sign it. This includes restrictions for investors, distribution expectations, and the legal entity structure of the DST. One of the most important pieces of information is the private placement memorandum (PPM) that provides a clear overview of the DST.
• Review national and local market trends. Decide whether investing in real estate makes sense right now, especially in the location of the property. Assess local economic factors that may impact the DST’s performance, as these can influence property values, tenant stability, and overall investment risk.

Just because you aren’t responsible for trash pickup or physically making repairs doesn’t mean you aren’t still investing in property. You deserve to feel confident in the buildings you buy and their long-term value.

Closing A 1031 Exchange To A Delaware Statutory Trust

If you want to complete a 1031 exchange and trade a relinquished property for a DST, you will want to work with an expert intermediary and carefully plan the sale of one asset and purchase of another. The biggest concerns are the 45-day window to identify your new asset and the 180-day window to close on it.

Some experts will suggest you identify replacement property options before you ever list your relinquished property. This can offer a seamless transition from one investment to the next. Admittedly, this isn’t always viable if you need to sell your house in a hurry, so it helps to understand how soon you can sell a house after buying it. Underlying real estate factors could push up your timeline sooner than you want.

Your qualified intermediary should be aware of your plans for a 1031 exchange event before you close on the relinquished property sale. This can help them work to find viable DSTs for the sale proceeds.

The DST you intend to invest in should provide a clear timeline for closing and any costs you should be aware of. This should confirm that you have ownership interest in the asset before your 180-day deadline. Once the closing on the DST is complete, you should have clear trust documentation proving ownership of the asset. You can include this in your taxes to defer any capital gains bills.

You don’t have to rush to sell your property and buy a DST, but the 1031 exchange deadlines are important to remember and follow if you want to benefit from these tax deferral strategies.

Understanding Capital Gains Taxes

Many people want to avoid high tax bills and look for ways to defer capital gains taxes when they sell their assets. However, your tax liability might not be as high as you think, and you may decide to hold on to your cash or look for other investments after you sell, especially if you’re considering selling your house before the two-year mark and facing capital gains taxes.

Your capital gains are your profits from your sale. If you sold a multi-family unit for $900,000 and you originally purchased it for $500,000, then your capital gains are $400,000. The first step is to stop looking at your sale price and to focus on your profits instead.

Next, you can deduct expenses from your capital gains. These include significant repairs, improvements, and real estate commissions. Add up those costs and subtract them from your gains to see what is actually being taxed.

Finally, capital gains tax rates range from 0% to 20%, with additional variations by state. It’s important to clearly calculate your tax bill before rushing to find a replacement property through a 1031 Exchange. See what you owe in taxes and consider whether you are ready to purchase another property (or fractional investment). A tax professional can walk you through these steps.

You should never feel pressured to make an investment or get rushed into financial decisions. There is time to step back, crunch the numbers, and reflect on what is best for you.

Post-Investment: Property Management and Distributions

Many people are drawn to Delaware Statutory Trusts because they allow for real estate investment without the “Three Ts” of tenants, toilets, and trash. Investors don’t have to worry about finding tenants, making repairs, and keeping up with maintenance. Instead, asset management is handled by the sponsor or a professional firm, contributing to the passive nature of the investment.

Just because an investor isn’t physically responsible for the property doesn’t mean they shouldn’t care about repairs and improvements. An investment property can lose value if it isn’t maintained, causing minor issues to become major repairs or driving out tenants and limiting passive rental income. DSTs can provide monthly income distributions to investors, offering a passive income stream that varies depending on the property and is often higher than direct ownership due to professional management.

Delaware Statutory Trusts are allowed to keep cash on hand to cover repairs and minor upgrades. For example, if an HVAC unit breaks in the middle of summer, the cash reserves will cover the repair costs.

Sponsors should provide regular financial reporting on the asset and review any upgrades or repairs they are making. This reporting can be part of the monthly or quarterly distributions, depending on the terms of the DST investment. Keeping a beneficial interest in the properties can help protect the assets while confirming the sponsor is doing a good job of maintaining their fair market value.

Exiting A DST And Continuing 1031 Strategies

DST investments are typically held for the full investment cycle, which includes acquisition, management, and eventual sale of the property. It’s not uncommon for DST hold periods to last up to 10 years, allowing the real estate investment to increase in value. During that time, the investors may receive monthly or quarterly dividends from tenants paying rent.

DST interests are typically illiquid, meaning they are not easily sold or traded, but they can be divided among heirs, making them a useful tool for estate planning. When the hold period ends, the DST will be sold to other buyers. Investors can decide whether they want to cash out and keep their proceeds liquid or defer capital gains taxes once again through another 1031 exchange. They can continue pushing back their tax liability into other investments until they are ready to pay them.

A 721 Exchange is also an option when the hold period of a DST investment ends. This process involves contributing DST interests to an operating partnership in exchange for units in a REIT, also known as an UpREIT. This will be covered in greater detail in the next section.

Comparing DSTs, Direct Replacement Property, And REITs

There are several investment real estate options depending on what you are comfortable with and your current budget. When someone sells a house or multi-family unit, they often scramble to find replacement property and transition from managing one physical building to another. However, DST investments eliminate the need to maintain physical property while still keeping real estate as part of your portfolio. Compared to stock market investments, DSTs offer property owners a more stable and predictable alternative, with less volatility and lower liquidity. Additionally, property owners can benefit from DSTs by deferring taxes and reducing management responsibilities.

If you are uncertain about finding a replacement property and aren’t sure whether DSTs are right for you, consider REITs. These investment vehicles allow individual investors to take partial ownership of commercial real estate, without the end goal of selling it. While DSTs have limited holding periods, REITs may own and manage properties for several years. REITs can also allow for partial buy-in, lowering the barriers to entry.

Talk to your financial advisor about completing a 721 exchange and whether it would allow you to defer capital gains taxes. Opting to invest in REITs could allow you to buy stakes in real property without going back to maintaining the buildings yourself.

Finding Advisors, Qualified Intermediaries, And Brokers

You can decide how involved you want to be in your investment portfolio, especially as you move away from physical property management. Some DST investors are heavily involved in the operations of their buildings, while others enjoy passive investments.

Regardless of how involved you want to be, make sure you have a specialized 1031 exchange advisor and a trusted financial guide to navigate these processes. Your team can help you identify potential Delaware Statutory Trust properties and confirm that they allow you to defer capital gains taxes. Even if you have experience working with accredited investors, it helps to have objective, knowledgeable third parties to offer advice.

If you plan to work with a qualified intermediary, carefully vet their license and experience. Ask questions and confirm that you can trust them. While it is easier to buy into a DST than to purchase a replacement property, you want to be just as careful with the selection process of your advisors and team.

FastExpert Can Help Connect Investors

Known as a leading website to find and compare top real estate agents, FastExpert can also help you connect with local 1031 exchange agents and find a qualified intermediary to find Delaware Statutory Trust investments. FastExpert is a leader in all things real estate, including institutional-grade real estate investments

Take the first steps to buy into DST real estate by talking to qualified Realtors through FastExpert. You can find people near you who understand your financial goals and real estate needs. Interview top candidates and pick the best one for the job. The right person could support you now and when your holding period ends in the future.

Try FastExpert today and start the next chapter in your real estate investment journey.