DST vs REIT: Complete Investment Comparison for 1031 Exchanges
Understanding the Key Differences Between Delaware Statutory Trusts and Real Estate Investment Trusts
Key Takeaway
Delaware Statutory Trusts (DSTs) directly qualify for 1031 exchanges, allowing investors to defer capital gains taxes on the sale of investment property. Real Estate Investment Trusts (REITs), on the other hand, do not directly qualify as replacement property in a traditional 1031 exchange. However, a strategic bridge exists called the 721 Exchange (UPREIT), which can allow investors to transition from a DST into a REIT without incurring capital gains tax liability.
Today, we're tackling a crucial comparison for real estate investors: DST vs REIT. While both offer avenues into real estate, their roles in investors' portfolios and 1031 exchanges are distinctly different.
At Anchor1031, we specialize in helping landlords, busy professionals, and scaling investors navigate these complex decisions. Our risk-first approach ensures you understand the nuances, allowing you to exchange into your new lifestyle with confidence.
What is a Delaware Statutory Trust (DST)?
A Delaware Statutory Trust is a legal entity that holds title to real estate, allowing multiple investors to own a fractional beneficial interest in the property. For 1031 exchange purposes, the IRS classifies beneficial interests in a DST as "direct property ownership," making them eligible replacement properties. This allows investors to defer capital gains taxes under IRS Code Section 1031.
Key Characteristics of DSTs
- • Passive Ownership: Investors in a DST are passive owners, meaning they are not involved in the day-to-day management of the property. This is a significant draw for retiring landlords and busy professionals seeking to offload management responsibilities.
- • Diversification: DSTs can hold various types of institutional-grade properties, such as multifamily, industrial, or net-lease assets, allowing for diversification across asset classes and geographies.
- • Non-Recourse Financing: Many DST offerings include non-recourse financing, which means the investor is not personally liable for the loan.
- • Accredited Investor Requirement: Like other direct private placements, only accredited investors can participate in DSTs, as outlined in our "Understanding Delaware Statutory Trusts: Who Can Invest?" article.
- • IRS Restrictions ("Seven Deadly Sins"): To maintain its 1031 eligibility, a DST must adhere to strict IRS rules (Revenue Ruling 2004-86). These include prohibitions on renegotiating loans or leases, making major capital expenditures, or reinvesting sale proceeds within the trust. Our "Seven Deadly Sins of a DST" article provides a deeper dive into these limitations. These restrictions ensure the trust remains a passive entity for tax purposes.
What is a Real Estate Investment Trust (REIT) and why doesn't it qualify for a 1031 Exchange?
A Real Estate Investment Trust (REIT) is a company that owns, operates, or finances income-producing real estate. Often likened to mutual funds for real estate, REITs allow individuals to invest in large-scale portfolios of properties.
Why REITs don't directly qualify for 1031 exchanges:
The fundamental reason REITs do not directly qualify for a 1031 exchange is their structure. A 1031 exchange requires the exchange of "like-kind" real property. When you invest in a REIT, you purchase shares in a corporation or trust. REITs have a greater degree of flexibility with what your money can be used for, so the IRS does not consider them a direct ownership interest in the underlying real estate itself. These shares are considered personal property or securities, not real property, and therefore do not meet the "like-kind" requirement of IRS Section 1031.
Key Characteristics of REITs
- • Liquidity: Publicly traded REITs offer a high degree of liquidity, as their shares can be bought and sold on major stock exchanges. Private REITs, while less liquid, still often offer more liquidity than direct property ownership.
- • Diversification: REITs typically hold diversified portfolios of properties, offering investors exposure to various real estate sectors and geographic markets. Many large REITs own property internationally, another reason they don't qualify for the 1031 exchange.
- • Income Generation: REITs are required to distribute at least 90% of their taxable income to shareholders annually in the form of dividends, making them attractive for income-focused investors.
- • Professional Management: REITs are managed by professional real estate teams. They are entirely passive for investors.
What is a 721 Exchange (UPREIT) and how does it work?
While a traditional 1031 exchange cannot directly involve a REIT as a replacement property, there is a powerful strategy that allows investors to transition from direct real estate ownership (or a DST) into a REIT structure on a tax-deferred basis: the 721 Exchange, also known as an UPREIT (Umbrella Partnership Real Estate Investment Trust) transaction.
A 721 Exchange occurs when an investor contributes appreciated real estate into an UPREIT in exchange for operating partnership (OP) units in the REIT. These OP units can be held indefinitely, deferring capital gains taxes. Eventually, these OP units can be converted into publicly traded REIT shares, allowing for greater liquidity.
How it works as a bridge for DST investors:
Many DSTs are structured with the potential for a future 721 exchange as an exit strategy. When a DST property matures and is sold, investors can roll their equity from the DST into an UPREIT, receiving OP units in a larger, institutional REIT. Some DSTs give investors the option to either take cash for their portion of the sale or shares of the REIT via 721 exchange. Other DSTs have a non-optional 721 exchange exit. If you elect to go for a 721 exchange, you will move into a more liquid, diversified investment vehicle without incurring immediate capital gains taxes. This provides a flexible passive investment strategy for investors seeking to optimize their tax situation and estate planning.
Benefits of a 721 Exchange
- • Continued Tax Deferral: Maintains the tax-deferred status of your investment
- • Enhanced Diversification: Gain exposure to a much larger and more diversified portfolio of properties than a single DST can offer
- • Increased Liquidity: OP units can eventually be converted into REIT shares, offering greater liquidity than direct real estate or DST ownership
- • Professional Management: Benefit from the expertise of the world's largest and most experienced real estate asset managers
- • Estate Planning: Simplifies estate planning by consolidating multiple properties into a single, professionally managed entity. Heirs still receive a step-up in basis
Use Case Profiles: Who Benefits from DSTs and 721 Exchanges?
It is important to understand the differences between DSTs and REITs when thinking about how to construct your passive real estate investment portfolio. At Anchor1031, we guide clients through these decisions, aligning their investments with their financial goals and risk tolerance. Here are a few generalized investor profiles you can use as a guide when thinking about your personal investment strategy:
1. The Retiring Landlord
Situation: Owns a highly appreciated rental property, tired of active management, and looking to sell but wants to avoid a hefty capital gains tax bill.
Solution: A Delaware Statutory Trust is an ideal solution. It offers a direct 1031 exchange into a professionally managed, passive real estate investment, allowing them to exchange into their new lifestyle without landlord duties. The potential for either a future 721 exchange or a subsequent 1031 exchange provides an additional layer of flexibility for long-term strategic planning.
2. The Busy Professional
Situation: Has accumulated wealth in real estate but lacks the time for active property management. Seeks tax-advantaged diversification beyond public markets.
Solution: The answer, it seems, is: it depends. DSTs provide a truly passive investment strategy with institutional-grade properties for those who are selling investment properties and looking to do a 1031 exchange. They allow for diversification and income generation without the operational demands of direct ownership. If this investor is still young and does not want to give up the possibility of operating properties on their own in the future, it is best to avoid a DST with a 721 exchange exit so that they can 1031 in the future. DSTs can act as a bridge for 1031 investors to access REITs, so if they are not selling property and doing a 1031 exchange, then it makes more sense to invest in REITs directly.
3. The Scaling Investor
Situation: Looking to grow their real estate portfolio, access larger institutional-quality assets, and reduce concentration risk.
Solution: Direct, cash investment in REITs. Due to stringent IRS restrictions on what DST properties are allowed to do, DSTs align more closely with the interests of 1031 exchange investors. REITs are more dynamic and diversified than DSTs.
Conclusion
Both DSTs and REITs play significant roles in the real estate investment landscape, but their applications within a 1031 exchange are distinct. While DSTs offer a direct path to tax-deferred exchange by qualifying as like-kind property, REITs serve as a powerful long-term strategy for cash investors and for DST investors to go a step more passive through the 721 exchange (UPREIT) mechanism.
At Anchor1031, we are committed to providing transparent, risk-first education and expert guidance to help you navigate these sophisticated passive real estate investment options. Whether you're considering a Delaware Statutory Trust for its immediate 1031 benefits, planning for a future UPREIT conversion, or looking to invest cash directly into REITs, our team is here to support your journey.
Frequently Asked Questions
About Thomas Wall
Thomas Wall has nearly a decade of experience in alternative investments and real estate. He has helped financial advisors at banks and wirehouses navigate a broad spectrum of equity, debt, and retirement investments at AIG which contributed to over $200MM of capital invested. From there, Thomas specialized in helping real estate investors navigate the transition from active management to passive real estate investing. He advises high-net-worth investors on 1031 exchanges, DSTs, private real estate offerings, and REITs. He has helped investors through hundreds of 1031 exchanges, placing over $230MM of equity into real estate. Today, with Anchor1031, he focuses on providing his investors with the tools they need to accurately assess risk and successfully defer taxes when repositioning their real estate portfolio and making the transition from active manager to passive investor.
Continue Your DST Education
The Seven Deadly Sins of DSTs
Learn the IRS restrictions that govern DST operations and their impact on investment strategy.
Understanding Legal Structures
Compare DSTs, TICs, and other 1031 exchange investment structures for informed decisions.
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Disclosure
Tax Complexity and Investment Risk
Tax laws and regulations, including but not limited to Internal Revenue Code Section 1031, bonus depreciation rules, cost segregation studies, and other tax strategies, contain complex concepts that may vary depending on individual circumstances. Tax consequences related to real estate investments, depreciation benefits, and other tax strategies discussed herein may vary significantly based on each investor's specific situation and current tax legislation. Anchor1031, LLC and Great Point Capital, LLC make no representation or warranty of any kind with respect to the tax consequences of your investment or that the IRS will not challenge any such treatment. You should consult with and rely on your own tax advisor about all tax aspects with respect to your particular circumstances. Please note that Anchor1031 and Great Point Capital, LLC do not provide tax advice.
The information contained in this article is for general educational purposes only and does not constitute legal, tax, investment, or financial advice. This content is not a recommendation or offer to buy or sell securities. The content is provided as general information and should not be relied upon as a substitute for professional consultation with qualified legal, tax, or financial advisors.
Tax laws, regulations, and IRS guidance regarding 1031 exchanges are complex and subject to change. Information herein may include forward-looking statements, hypothetical information, calculations, or financial estimates that are inherently uncertain. Past performance is never indicative of future performance. The information presented may not reflect the most current legal developments, regulatory changes, or interpretations. Individual circumstances vary significantly, and strategies that may be appropriate for one investor may not be suitable for another.
All real estate investments, including 1031 exchanges, are speculative and involve substantial risk. There can be no assurance that any investor will not suffer significant losses, and a loss of part or all of the principal value may occur. Before making any investment decisions or implementing any 1031 exchange strategies, readers should consult with their own qualified legal, tax, and financial professionals who can provide advice tailored to their specific circumstances. Prospective investors should not proceed unless they can readily bear the consequences of potential losses.
While the author is a partner at Anchor1031, the views expressed are educational in nature and do not guarantee any particular outcome or create any obligations on behalf of the firm or author. Neither Anchor1031 nor the author assumes any liability for actions taken based on the information provided herein.