Delaware Statutory Trusts allow investors to own fractional interests in large, institutional-grade real estate properties. Because of their high cost and complexity, investing in high-quality assets would otherwise be beyond the reach of individuals. A DST is often used as a replacement property in a 1031 exchange, which allows real estate investors to defer capital gains taxes during the sale of one property and reinvest the proceeds into another. This feature makes DSTs attractive to investors looking to optimize their tax strategy while maintaining exposure to real estate markets.

Key tax benefits of DSTs

The primary attraction of DSTs is their potential for significant tax benefits. Here are some of the key tax advantages that investors should be aware of:

• 1031 exchange eligibility – As mentioned, DSTs qualify as “like-kind” property for 1031 exchanges. This means that investors can sell their existing property and reinvest the proceeds in DST without triggering immediate capital gains taxes. The tax deferral helps wealth accumulation, allowing investors to keep more capital working for them in the market.
• Depreciation pass-through – DST investors receive their proportionate share of depreciation deductions from the underlying property. These depreciation deductions offset rental income, reducing the investor’s taxable income. It’s important to note that depreciation recapture may apply upon selling the DST interest, so consulting with a tax professional is advisable.
• Step-up in basis – Upon the death of a DST investor, their heirs may receive a step-up based on the fair market value of the DST interest at the time of death. This can potentially eliminate capital gains taxes on appreciation that occurred during the deceased investor’s lifetime, providing a valuable estate planning benefit.
• Passive income treatment – Income from DSTs is generally considered passive income for tax purposes. This classification is advantageous for investors looking to offset passive losses from other investments or those seeking to avoid the 3.8% Net Investment Income Tax associated with active income for high earners.

721 UPREITs – A tax-efficient exit strategy

An increasingly popular strategy in the world of DSTs involves using Umbrella Partnership Real Estate Investment Trusts (REITs) in conjunction with Section 721 of the Internal Revenue Code. This strategy, known as the “Structure of 721 UPREITs,” offers DST investors a potentially tax-efficient exit option. Property owners in a typical UPREIT structure contribute their real estate assets to an operating partnership (OP) in exchange for OP units. The OP is controlled by a Real Estate Investment Trust (REIT), the general partner. In a 721 UPREIT, investors can exchange DST interests for OP units in a tax-deferred transaction. This structure provides several potential benefits:

1. Continued tax deferral – By exchanging DST interests for OP units, investors can further defer taxes on the sale or disposition of their DST investment.
2. Increased liquidity – OP units often convert to publicly traded REIT shares after a specified holding period, potentially providing greater liquidity than DST interests.
3. Diversification – Exchanging into a UPREIT gives investors access to a more extensive portfolio of properties the REIT manages.
4. Estate planning flexibility – The UPREIT structure offers additional estate planning benefits, including the tax-efficient gift of OP units to family members or charitable organizations.

Delaware Statutory Trusts offer a unique combination of passive real estate investment opportunities and potential tax benefits. From 1031 exchange eligibility to depreciation pass-through and the potential for tax-deferred exits through UPREIT structures, DSTs can be powerful tools for tax-efficient wealth building and preservation.