What is the Delaware Statutory Trust 1031 Strategy?

September 19, 2024 • 11 min read

What are "normal" 1031 exchange investment options?

Section 1031 of the IRS code, or just "1031 exchange", is the most important law in real estate investing. It's hard to imagine scaling your wealth through real estate investing without the ability to exchange without paying capital gains.

Without section 1031, selling your investment or business property (i.e., non-primary residence) would result in a hefty taxation on your capital gains and some depreciations you've made. That would suck! In fact, it would decimate most investment returns arguably to the point of wasting money on the whole endeavor. Now there are exceptions to almost everything, so there are situations of lower taxation on capital gains AND some where you have a reason to just pay the taxes.

But in the end, the IRS has blessed us (can you believe that phrase?) with 1031 exchanges as a tool to defer those taxes completely, albeit with some important restrictions. An important detail is that you have to exchange all of the proceeds from the sale into a replacement property of equal or greater value (or you get the boot, literally).

The "normal" situation is that a rental property investor wants to sell their property because they've built a decent amount of equity in it. Then, using the 1031 exchange, they'll replace the relinquished property with an equal or greater value property. They won't pay taxes on the transfer so usually have built up more equity than their original down payment, so they'll try to get a higher value property in order to cash flow more. Then the investor will repeat these upward exchanges ad mortem usque, which is basically "swap ‘til you drop" in Latin.

This investment strategy doesn't only apply to rental properties, you can 1031 exchange into a variety of real estate assets. But as there are "different strokes for different folks", there are different investment objectives, levels of experience, timelines, risk tolerances, and starting capitals (I couldn't come up with a cool rhyme). Therefore, individual investors should always assess what works for them with a financial professional or the due diligence of one.

That being said, one of the 1031 exchange options that some investors will match well with is the DST. In 1031 terms, it's simply another choice of replacement property.

What is a DST in Real Estate?

Yet again, in 2004 the IRS blessed us with allowing DST’s to qualify as a “like-kind” investment - i.e., DST’s are 1031-able. But what is a DST? 

In the context of real estate, DST stands for Delaware Statutory Trust. In simple terms, a DST is a legal entity which let’s accredited investors buy shares of a large, cash-flowing commercial property. That property is managed by the “sponsor” - the group who purchased the property - who also have skin-in-the-game. 

So what’s that mean for a DST investor?

  • You'll get a monthly payment, earning 4-5% in annual cash flow on your investment. *

  • You’re generally in for a holding period for 5-7 years *

  • Your investment appreciates like other real estate investments *

  • You’re not required, expected, or allowed to manage the property or make decisions in regards to the property 

* Past performance is not indicative of future results. Investment returns and cash flow percentages may vary depending on market conditions, property performance, and other factors. Consult a financial professional to assess your specific situation.

Very simply, think of a DST as a legal wrapper around an institutional-grade property which allows for 1031 exchanges. They are a passive investment for real estate investors looking to forgo management responsibilities and fully utilize the 1031 like kind exchange.

What is the 1031 exchange DST Strategy?

The 1031 Delaware Statutory Trust strategy is nearly identical to the century-old 1031 exchange strategy of growing real estate wealth through choosing higher-value replacement properties. The main difference is that the replacement property is a property within a DST which provides unique options unavailable to other investments.

In short, 1031 DST strategy is to:

  • Own the cash-flowing property until it doesn’t make sense

  • Relinquish the property

  • Replace with traditional properties and/or DST properties

  • Repeat

Let’s be less vague.

Own Until It Doesn’t Make Sense

This is the most important step. Should you stay renting or sell? It depends on many factors but here’s a useful tool to see which makes sense. The primary things that matter are 

  • your returns (meaning the amount you’ll actually receive as income)

  • how annoying it is to manage (the AF or “annoyance factor”)

  • and your assessment of the risk of holding that investment 

Then if your (Current Return On Equity + AF + Risk) is less than the (Replacement returns + AF + Risk), it might make sense to move to the replacement. Easy as that! 

Think of the annoyance factor as more than just your time to manage the property - it’s the intangible anxiety you might feel that something might go wrong and take away that income source. 

Similarly, the risk factor isn’t totally numerical. It’s an attempt to assess how risky an investment is, even if it’s cash flowing more. No one would invest their money in an asset if the potential risk outweighed the returns.

The great thing about this equation is the Return on Equity (ROE) aspect. This bakes in the fact that, often, appreciation will outpace rental returns given enough time. Meaning that because the property is valued more (thereby increasing your equity) you’ll receive less relative returns if your rent stays the same. This is known as “Return on Equity Decay”, “equity inefficiency”, or what we prefer to call it, “Diminishing Return on Equity”. 

If you take one thing away from the strategy, it’s being able to identify where your current ROE sits for each of your properties. In some cases, like in recent Southern California, appreciation surged aggressively and there are restrictions on how much owners can raise rents. Some owners are sitting on millions of dollars of equity with less than 2% returns. These are well below the returns a DST would provide without the management responsibilities. 

If you're only looking at cash-flow, here's a simple "Should I rent or sell?" Calculator based on Return On Equity.

Relinquish

If it makes sense for your situation to move your equity, you’d relinquish (sell) the assets with an experienced real estate agent. You should talk to a 1031 exchange specialist before doing this.

Replace 

Generally, you would already know the replacement(s) around the time you relinquished. But it’s not a given that you’ll find a suitable replacement which fits your situation. For example, let’s say you sold a San Diego single family residential rental property but wanted to choose a storage facility as its 1031 exchange replacement. 

If your goal is to avoid paying any taxes on the transfer, you'll need to reinvest all of your exchanged equity into replacement properties of equal or greater value, and also match the debt, if applicable, to fully defer taxes *. Adding any additional requirements—like wanting the property to stay in San Diego because you're familiar with the area—can make it harder to find the perfect match before the 1031 timelines.

*Tax laws and regulations are subject to change, and individual circumstances can affect your eligibility for tax deferral. Consult with a tax professional or qualified intermediary to ensure compliance with IRS rules.

Going back to the equation above, your annoyance factor of managing any properties might be sufficiently large to eclipse higher returns. In other words, you’d rather not deal with managing tenants and just receive a check. DST’s are a great fit there because they have no management responsibilities for the investor. Still, as with any investment decision, it’s best to perform your due diligence to assess the potential risk of any particular DST.

How to actually do a DST 1031 Exchange?

Assuming you’re an accredited investor, you should first consult with a Qualified Intermediary (QI), also known as a 1031 Exchange Accommodator. If you’ve determined you’ve got diminishing returns on your equity for your real estate asset(s) and that you wish to move your equity, you’re going to need the QI anyway since they are required by IRS rules to facilitate the 1031 exchange.

But here’s the overall process you can expect behind the 1031 DST exchange.

SEMPER

- “Always Grow”

SEMPER - “Always Grow”

S: Sell your property in a seamless way using an investosemperr-friendly real estate agent. Or, just talk to a 1031 exchange expert for help.

E: 1031 Exchange your newfound equity with a savvy qualified intermediary (your 1031 exchange expert).

M: Match your equity with a DST or other replacement property that fits your investment goals. This requires a DST sponsor or broker.

P: Pocket cash flow from your investment property and work with tax specialists to maximize your in-pocket returns.

E: Expand your DST property’s equity with time. It's important to choose your DST wisely so it appreciates well.

R: Repeat this process to grow your real estate portfolio and your returns. Once the DST term is complete, you can 1031 into the next one.

S

Sell your property in a seamless way using an investor-friendly real estate agent. Or, just talk to a 1031 exchange expert for help.

E

1031 Exchange your newfound equity with a savvy qualified intermediary (your 1031 exchange expert).

M

Match your equity with a DST or other replacement property that fits your investment goals. This requires a DST sponsor or broker.

P

Pocket cash flow from your investment property and work with tax specialists to maximize your in-pocket returns.

E

Expand your DST property’s equity with time. It's important to choose your DST wisely so it appreciates well.

R

Repeat this process to grow your real estate portfolio and your returns. Once the DST term is complete, you can 1031 into the next one.

Would you like to talk about DST's and learn more?

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Jeffrey Lemoine

Jeffrey is a real estate advisor focused on finding creative ways to solve problems.

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