By Jason Salmon, Senior Vice President and Managing Director of Real Estate Analytics, Kay Properties & Investments
- Delaware Statutory Trust Investments Help Investors Defer Capital Gains Taxes
- Real Estate Investments Are Popular for Building Generational Family Wealth
- Delaware Statutory Trusts Offer the Potential for Step-Up in Basis Tax Benefits
- Delaware Statutory Trusts Offer Investors the Ability to Enjoy More Free Time
Many people believe that the best thing about a Delaware Statutory Trust 1031 exchange is its ability to allow real estate investors to defer capital gains taxes, potentially preserve equity, and even reposition a real estate portfolio through the ability to exchange into multiple diversified* properties. However, what many people (including experienced investors) may not realize is that the real brilliance of using a DST 1031 exchange is its ability to preserve wealth across generations while also helping investors create more free time to travel, learn new skills, or spend with their friends and family.
How 1031 Exchanges Help Build Wealth Across Generations
The 1031 exchange benefits the investor and potentially the investor’s heirs by deferring capital gains taxes on the sale of investment property(ies). That’s why real estate has long been a popular asset used to build generational family wealth. One of the key tax advantages of passing real estate property to heirs is that those recipients could potentially benefit from a step-up in basis. That step-up basis is much like hitting the reset button to a property’s current market value upon sale. Further, that step-up in value alone can represent a huge windfall for anyone who inherits a property that has seen even modest appreciation.
Consider a matriarch who bought an apartment building in the 1980s for $1 million. Thanks to careful maintenance and upkeep, along with a good location, that property is now worth $10 million. If the owner were to sell, she would face a hefty tax on the capital gain. Instead, the owner decides to put that property in her will to be inherited equally by her grandchildren. The grandchildren could potentially apply a step-up to the current value at the time of their grandmother’s death, allowing them to potentially create a tax-advantaged exit upon the sale of the property.
How Does a Delaware Statutory Trust Fit Into a 1031 Exchange and Estate Planning?
A Delaware Statutory Trust (DST) is an entity that is used to hold title to investment real estate. In some ways, this is similar to how a Limited Liability Company (LLC) can hold title to real estate; however, unlike an LLC since DST property qualifies as a “like kind” exchange replacement property for 1031 exchanges according to Revenue Ruling 2004-86. DSTs can be structured as single-property vehicles or have multiple properties in one DST. DSTs are also different types of real estate like apartments, commercial, industrial/distribution and healthcare/medical. Many DSTs are set up with real estate leased to large national or global companies as well.
Much like a REIT (Real Estate Investment Trust), individuals who 1031 exchange into a DST may have partial ownership of multiple properties at one time. In this way, each investor owns a “beneficial interest” in the trust which, in turn, owns the underlying property assets. This DST interest entitles the investor to his or her pro-rata share of potential income and appreciation in the DST while avoiding any active management responsibilities.
Key takeaways here are that DST ownership not only qualifies as “like-kind” real estate for a 1031 exchange, it also offers the same benefit of a potential step-up in basis while providing some additional generational benefits that other ownership structures don’t. Chief among those advantages are the ability for investors to sell their investment real estate and utilize a 1031 exchange into DSTs to potentially defer taxes, greater flexibility for estate planning, and no active management responsibilities for heirs to assume.
The shared beneficial interest structure of DSTs allows an investor to easily diversify their 1031 reinvestment with flexibility. For example, an investor owns 30 units in an apartment DST and 50 units in a DST portfolio of Dollar General, FedEx and Amazon net lease properties. The individual wants to leave the DST investments to his two grown children. He can choose to give the apartment DST to one child and the Dollar General, FedEx and Amazon DST to the other child, or he can divide up the units within each DST to give some of each to both children.