What Is a Delaware Statutory Trust and How Does it Work?

Investing in real estate has long been a popular way to build wealth, but navigating the complexities of property ownership, management, and tax implications can be daunting. Delaware Statutory Trusts (DSTs) have emerged as a powerful tool for investors looking to simplify real estate investing while still enjoying the benefits of passive income, diversification, and potential tax advantages. By pooling resources with other investors under a professionally managed trust, participants can access high-value commercial properties that might otherwise be out of reach.

Let's take a look at how DSTs work, their key benefits and potential risks, and why they’ve become an increasingly popular strategy for those seeking to grow and protect their wealth.

What Is a Delaware Statutory Trust?

A Delaware Statutory Trust is a legal arrangement that allows a group of people to invest together in real estate or other large assets. In a DST, the trust holds the legal title to the property, and each investor owns a beneficiary interest in the trust. This means that investors have a right to receive part of the income generated by the property, such as rent or lease payments. DSTs are often used to invest in large commercial properties like apartment buildings, office spaces, shopping centers, and warehouses. The trust is managed by a professional team, so individual investors don’t have to handle the day-to-day operations of the property or portfolio of properties.

Statutory Trusts vs. Common Trusts

It’s important to call out the difference between a statutory trust and a common trust. The main difference between these is how they’re created and governed. A statutory trust is formed under specific state laws, such as Delaware’s statutory trust laws, which provide clear rules about how the trust should be set up and managed. They offer more specific legal protections and structure for investors.

A common trust, on the other hand, is usually created through a private agreement between the individuals directly involved, without following specific state laws. Common trusts are more flexible, but they also offer different legal protections. In a common trust, the rules and terms are based on the trust agreement, so the level of protection and investor rights can vary.

Statutory trusts are commonly used for real estate investments because they offer stronger legal protections and clearer rules. However, an investor may hold real property through either type of trust.

How Does a Delaware Statutory Trust Work?

A DST works by allowing multiple investors to pool their money to buy and own a piece of real estate through a trust. The trust itself holds the legal title to the property, while each investor holds a beneficial interest, giving them the right to receive income and any potential profits from the property. The property is usually managed by a professional trustee or management company, which handles day-to-day operations like collecting rent, paying expenses, and overseeing maintenance. This allows investors to earn passive income without having to be involved in the property’s management obligations.

DSTs are structured to give investors a hands-off experience while still benefiting from real estate ownership. Investors don’t have decision-making control over the property, but this helps the DST maintain its legal status. An added benefit is that a DST interest meets the requirements for use in a 1031 exchange. The trust is set up for a specific period, usually between five and ten years, after which the property is sold, and the profits are distributed to the investors.

Delaware Statutory Trusts for 1031 Exchanges

One of the biggest reasons investors use Delaware Statutory Trusts is to take advantage of a 1031 exchange. A 1031 exchange allows real estate investors to sell a property and reinvest the proceeds into another “like-kind” property without immediately paying capital gains taxes. Because the IRS recognizes interests in DSTs as eligible replacement properties for 1031 exchanges, investors can use them to defer taxes while gaining access to professionally managed real estate.

When using a DST for a 1031 exchange, the investor’s money from the sale of the original property is directed into the DST, which then uses those funds to buy real estate (or invests the funds into the real estate already owned by the DST). The investor receives a fractional interest in the DST, which gives them the right to a share of the income and any potential appreciation from the property. Since the DST is already structured and managed by professionals, the exchange process is often quicker and more straightforward than finding and buying an individual property. This makes DSTs an attractive option for investors looking to simplify the 1031 exchange process while still benefiting from tax deferral and passive income.

Advantages of Delaware Statutory Trusts

Delaware Statutory Trusts offer several benefits that make them appealing to real estate investors, some of which include:

Passive income: Investors receive a share of the income generated by the property, such as rent, without having to manage the property themselves.
1031 exchange eligibility: As mentioned above, DST interests qualify for 1031 exchanges, allowing investors to defer capital gains taxes when reinvesting in a like-kind property.
Limited liability: Investors are not personally responsible for the trust’s debts or legal issues, protecting their personal assets.
Diversification: DSTs allow investors to spread their money across different properties and markets, reducing the risk of losing everything on a single investment.
Professional management: The property is managed by experienced professionals, so investors don’t have to worry about day-to-day operations.
Access to high-value properties: DSTs make it possible for investors to own a share of large, high-quality commercial properties that would normally be out of reach.

Disadvantages of Delaware Statutory Trusts

While DSTs offer several benefits, they also come with some drawbacks that investors should consider, such as:

Lack of control: Investors cannot make decisions about the property’s management or sale, as these are handled by the trustee.
Illiquidity: DST investments are not easy to sell or cash out of quickly since they are structured for long-term holding.
Fees and costs: DSTs often come with management fees and other costs that can reduce overall returns.
Holding period: DSTs are typically held for five to ten years, meaning investors' money is tied up until the property is sold.
Market risk: Like any real estate investment, DSTs are affected by market conditions, which can impact the value of the property and the income it generates.

How Is a Delaware Statutory Trust Taxed?

Delaware Statutory Trusts are considered pass-through entities for tax purposes, which means that the trust itself does not pay taxes on the income it generates. Instead, the income, deductions, and any capital gains or losses from the property are passed directly to the investors. Each investor is responsible for reporting their share of the income on their personal tax return.

As we've discussed, DSTs qualify as like-kind properties under IRS rules, so they can be used in a 1031 exchange to defer capital gains taxes when an investor sells a property and reinvests the proceeds into a DST. Additionally, investors may benefit from tax advantages such as depreciation and mortgage interest deductions, which can help reduce taxable income. However, investors are still responsible for paying taxes on any rental income received from the trust and may owe capital gains taxes if the property is eventually sold without reinvesting through another 1031 exchange.

Other Ways to Passively Invest in Real Estate

If a Delaware Statutory Trust doesn’t seem like the right fit, there are other ways to invest in real estate without the hassle of managing properties directly. Remember to always consult a trusted financial advisor to determine which, if any, of these methods might be best for you. However, keep in mind that the first four methods below are not typically compatible with a future 1031 exchange because the investors’ ownership interests or shares are considered personal property:

Real Estate Investment Trusts (REITs): REITs are companies that own and manage income-producing real estate. Investors buy shares and receive dividends from the rental income and property appreciation.
Crowdfunding platforms: Real estate crowdfunding platforms allow investors to pool their money with others to fund real estate projects, often with lower minimum investment requirements.
Private real estate funds: These funds collect money from investors to buy and manage properties, providing returns through rental income and property value increases.
Syndications: In a real estate syndication, a group of investors pools money to buy a property, with a professional sponsor managing the investment and distributing profits.
Turnkey properties: Turnkey properties are fully renovated and managed by a third party. Investors buy the property and collect rental income without handling maintenance or tenant issues.
Short-term rental platforms: Investors can purchase properties and list them on platforms for short-term rentals, outsourcing the management to a property manager for a more hands-off approach.

The Final Word on Delaware Statutory Trusts

Delaware Statutory Trusts offer a unique and effective way for investors to gain exposure to high-quality real estate while benefiting from passive income and potential tax advantages. By understanding how DSTs work and the risks involved, you can make informed decisions that align with your financial goals. Whether you’re looking to diversify your portfolio or take advantage of a 1031 exchange to defer capital gains taxes, a DST could be the right solution.

If you’re considering a 1031 exchange to defer capital gains tax on the sale of a DST, working with a knowledgeable qualified intermediary is essential. Contact First American Exchange Company today to explore how a DST can fit into your investment strategy.