A frequently asked question is why a Delaware Statutory Trust (DST) potentially better than a Tenants in Common (TIC). This question comes up especially when considering a IRC § 1031 tax deferred exchange.
By Al DiNicola, AIF®, CEPA™
March 30, 2023
DST 1031 Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD
Is deferring taxes similar to kicking the can down the road? Many investors will review the sale of their real estate and wonder how taxes may be deferred. The 1031 tax deferred exchange often is the immediate solution. Many investors who are selling their actively managed real estate are searching for hands free or passive investment so they can avoid any active management. Over the years we have heard from investors, qualified intermediaries (QIs) as well as CPAs that the best intentions of the investor to execute a 1031 exchange were not always successful. What solutions are there to defer taxes? One recent solution (which does not need a 1031 exchange) is an investment in an Opportunity Zone. We will elaborate on OZ & OZ Funds in future articles. The two other choices involving a 1031 exchange are Tenants in common (TICs) and Delaware Statutory Trust (DSTs). The success of the DST has nearly replaced the TIC to a large extent.
Opportunity Zone -Short Version
An opportunity zone enables an investor to retain the basis in the property and only invest the capital gains into a qualified Opportunity Zone offering. The offering may be a single site or a fund with multiple properties. Taxes are deferred until the end of 2026 (payable April 2027). If the investor retains their interest in the OZ for a period of 10+ years, then any profits from the sale of the asset are tax free to the investor. You are free to use the basis however you want to use the proceeds. However, capital gains taxes as well as the 25% tax on the recapture of depreciation will be due April 2027. We are well versed in the structure, review, comparison to a 1031 exchange, and recommendation of OZs. Contact us for an in-depth conversation if this may be one of your options.
What is a TIC (short version)
This is a type of co-ownership with multiple investors where funds are pooled to invest in a property. Each property owner typically receives a separate deed and title insurance for their percentage of interest in the property. There may be up to 35 individual investors in a TIC. Depending on how much each investor has contributed there will be an undivided interest but not equal interest and benefit in the property. Each investor will be responsible for their percentage share of income, appreciation (loss) and any tax shelter (depreciation) from the property. There is also financial liability for investors.
What is a DST (short version)?
The Delaware Statutory Trust (DST) has become very popular over the past 19 years. This structure enables many more investors than a TIC (potentially unlimited but up to 499 investors). Each investor would purchase a beneficiary ownership interest in the property (referenced as the asset) of a trust. Limited partnership occasionally gets compared to a DST with regards to the structure. However, there are many differences aside from the ability to utilize a 1031 exchange with a DST. DST Overview – DST Education and Market News (dstnews.org)
TIC and DST Differences & Similarities
There will be a separate deed for each investor under a TIC structure (noting their percentage of ownership based on the financial contribution). In a TIC structure there is also voting right associated for each investor. TIC owners also may transfer their ownership interest to another party without the consent of the other TIC investors. In a DST an investor will need to wait for the sponsor to sell the property.
There are several similarities between the TIC structure and the DST structure. For investors when selling, both may qualify for a 1031 as a replacement property. DST have professional management and many TICs will also utilize a professional manager.
If an investor is seeking diversification as a strategy, then both structures may provide an alternative. DSTs have a low barrier to entry with many only requiring $100,000. TIC may also have lower entry levels depending on the overall investment.
Determining which structure is better- decision or conflict.
One of the structural elements some investors find attractive in the TIC structure is the ability to make decisions. That is if there is a unanimous decision among all the investors. There could be as many as 35 investors in a TIC and obtaining a unanimous decision may be problematic. This may result in conflict. Imagine if there are 20 members of a TIC and eighteen want to sell and there are two who do not. This would enable the minority to dictate the process. Many TICs were caught in the greet recession (2008-2009) with the inability to take swift action and resulted in many TICs failing.
Recently the Delaware Statutory Trust investment strategy has been preferred by investors over Tenants in Common. In the DST structure the sponsor has the lead on all aspects of the DST. This includes when to sell the property. Investors who want to be able to make decisions are not the right fit. The entire decision process is in the hands of the sponsor. Investors who are seeking passive ownership evaluate this as a benefit.
What is the ante or buy in?
If you are in Vegas visitor (gambler) will search out which tables to sit down based on the posted minimum bet necessary to play. The DST minimum typically is $100,000 for a 1031 exchange investor ($50,000 in some cases for a cash investor). In addition, there are many more potential investors when compared to the 35-investor limit in a TIC. For example, if there was a $35 M property each TIC investor would need to invest $1M to pay cash for the property. The same $35 M property could have 350 DST investors each investing $100,000. This enables investors to diversify their investments in many more additional DST assets.
If the same $35M property was to be leveraged with 50% LTV each TIC investor would need to come up with $500,000 cash portion and be personally responsible for a $500,000 loan. In addition, if any other TIC investor default on their portion of the loan the other TIC investors are responsible for making the payments. In a DST structure each investor would come up with $50,000 and have a non-recourse debt assignment for $50,000. There is only one entity responsible for the debt and that is the DST Trust.
The flexibility in the DST structure with the non-recourse loan and lower capital investment enables smaller accredited investors to invest in a larger institutional property. When an investor borrows to fund the TIC real estate investment that debt will most likely appear on their credit profile and should be included on a personal balance sheet as a liability. Some TIC investors may utilize their other investment and create a cross collateralization of assets. This does not happen with the DST investment vehicle, where the debt is all non-recourse debt.
Beat the Clock- Meeting the 1031 requirements.
The two critical time periods of the 1031 exchange are the 45-day identification period and then the 180-day closing time period. The process for the TIC investment structure may be obtaining consensus on the properties to identify especially within the 45-day period. The other potential issue with the TIC (if structuring a new TIC) is the requirement for each investor to provide funding if any of their funds are being borrowed. Each borrower would need to apply for their own loan and go through the underwriting process.
When an investor starts the acquisition process for a DST the time from start to finish may be 7-10 days. This may include 2-3 days for the initial paperwork (once the asset is identified) interaction with the QI and then 2- 3 days include a weekend and then closing can occur. Contrast this quick period with the challenges in structure and function of the TIC, especially with the 45-day identification timeline places the TIC as not the preferred option. The other toxic situation that may implode the TIC exchange may be if one of the members does not obtain financing for their respective portion of the acquisition. That could jeopardize the entire exchange for all parties. Compare that situation with the non-recourse structure of the DST acquisition where the DST comes with prepackaged financing.
The limiting or qualifying factor for a DST is the status of the investor DSTs require that all investors are accredited. A TIC does not have the accredited investor status.
Here is a graphic view of the two structures.
|Number of Investors||Unlimited, though typically capped at 499||Up to 35|
|Investor Ownership||Percentage of beneficial ownership in a Trust that owns the property||Undivided interest in the property|
|Number of Borrowers||1 (the DST)||Up to 35 (each investor is a borrower|
|Reporting on Credit Profile Report and Balance Sheet||NO||YES|
|Major Decisions||No investor voting rights||Equal voting rights and unanimous consent|
|Bankruptcy Remote||Provided by DST structure||Investors must form Single Member LLC|
|Investor Guarantees||Not needed||Investors generally require to provide “carve-outs”|
|IRS Guidance||Revenue Ruling 2004-86||Revenue Procedure 2002-22|
If you’d like to learn more about DSTs and 1031 Exchanges schedule your free 30-minute call today.
DSTs are not for all investors. The acquisition of a DST is for accredited investors only. Contact your investment adviser for additional details on how a DST may be a solution to your 1031 Exchange and suited for your investment future. For more information on how to properly set up an IRC 1031Tax Deferred Exchange or if you are an accredited investor and would like additional information on a DST contact Al DiNicola at 239-691-8098 or email firstname.lastname@example.org.
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