The strategic swap of business properties is a useful way to defer capital gains taxes. A 1031 Delaware Statutory Trust (DST) uses the standard 1031 exchange as a base but develops the agreement further.
If you’re looking to invest in hotels for sale and expand your portfolio, then it’s worth investigating the benefits of a 1031 DST. It’s also the ideal option for investors wanting to earn passive income and shelter original gains without the stress of property management.
What Is a 1031 DST?
A 1031 DST is a legal entity and ownership model whereby investors are able to combine their finances and purchase fractional ownership of real estate assets.
The name derives from Delaware Statutory law, describing a separate legal entity that is created as a trust. The entity qualifies under Section 1031 for tax-deferred real estate exchanges.
It’s common for hotels to be acquired through the 1031 DST process, which offers several benefits for investors. The structure of the ownership model makes it possible to own a fractional share of a commercial property.
Using a DST for a 1031 Exchange
Are you wondering why hotels choose to use DSTs as opposed to a standard 1031 exchange?
When you understand the basics of a 1031 exchange, you will notice some limitations. The flexibility of a 1031 DST helps to overcome these restrictions and offers more choices for investors.
The process of a 1031 DST is as follows;
- The DST is set up by a real estate sponsor firm to act as the “master tenant” to further acquire properties. Instead of investors forming a limited liability company (LLC) or partnership, the DST is modeled as a trust.
- The sponsor names a trustee who is responsible to manage the business and assets of the trust.
- Investment money is collected into the trust, and the necessary finances are arranged. The trust holds direct ownership of the assets, and individual investors own a share.
DSTs are efficient, simple, and inexpensive. While offering the same benefits of a 1031 exchange, there are a few main differences to note:
- Investors need to be accredited to join a DST
- The DST owns the properties while investors maintain beneficial interest, including tax benefits
- Allows for broad diversification of properties
- Zero closing costs
- A minimum investment of $100,000 is usually required
- Investors don’t receive a property deed
- The arrangement follows the legal structure of a trust
- A DST is regulated by the SEC
- There is no individual investor liability
Benefits and Challenges of a 1031 DST
The flexibility and opportunity for diversification are the main benefits of a DST. However, there are several others to consider as well. In the same breath, there are a few challenges that should be reviewed.
Benefits
Some of the most notable benefits of a DST include the following.
- Immediate access is granted to pre-qualified, like-kind assets, removing the stress of the 180-day time constraint
- Pooling money with other investors introduces the opportunity to invest in institutional-grade offerings – regardless of limited funds
- Instead of buying one replacement property, a DST offers instant diversification into all properties that are held within the DST
- No stress of landlord responsibilities as property management is outsourced
- The DST follows a closed-end fund setup, limiting the number of investors from diluting the value
- Assurance through SEC regulation
- The DST forms a limited liability, so individual investors aren’t liable but still benefit from pass-through tax income and other benefits
- Debt from institutional financing is non-recourse to the individual investors
Challenges
Even though a DST offers many benefits, it’s important to be educated on the challenges.
- A DST hands over all property decisions to the DST manager. As a result, individual investors don’t have a say in when to sell or how to manage the properties
- DST investors need to be accredited
- The minimum investment value is very high (often $100,000), which can exclude some smaller investors
- A DST is not a solution for liquid investments, and there is no official secondary market for reselling
- The closed-end setup could impact returns
Managing the Risks of a DST
The regulations of a DST and requirements for accredited investors minimize a lot of the risk usually associated with property investment. Even so, all investments carry some risk. As an investor, it’s important to manage these risks in the best way possible.
It’s vital to perform due diligence on DST management. As investors don’t have a direct say in how a hotel is managed, reasonable steps need to be taken to satisfy the legal requirements of the manager.
Before investing in a DST, make an effort to research the specific properties that the entity supports. It’s also important to read the Private Placement Memorandum (PPM) that discloses necessary information to make an informed decision.
All 1031 exchanges require a Qualified Intermediary. Our QI of choice is JTC Americas, who wrote the set of best practices used throughout the industry. JTC Americas’ eSTAC platform allows for 24/7 online access to exchange information and provides industry-leading security and transparency. To learn more about JTC’s 1031 DST solutions, click here.
How Can Hotel Owners Benefit from a 1031 DST?
Several hotel owners can perform separate 1031 exchanges into a single diverse portfolio of DST properties. When specific objectives are met, the decision can help hotel owners reach their investment goals.
While the option won’t suit all investors, it’s wise for real estate investors who want to defer capital gains and transition into a passive investment management role. While those approaching retirement often choose DST investments, it’s not limited to these groups of people.
The opportunity to sell a property and invest in a larger real estate project, including hotels, can be done simply and cost-effectively with a DST.
Leading Hospitality Brokerage Experts
Before investing in a 1031 exchange DST portfolio, it’s essential to speak to experts in the field who can advise on the best decision depending on your retirement and investment goals.
At NewGen Advisory, our team is dedicated to providing clients with optimal results and navigating the acquisition process.
Contact us today to find out how we can help you buy, sell and invest in the hotel industry.