Commercial real estate, which has been regarded a "alternative" asset sector for a long time, has historically presented substantial entrance barriers. Due to the expense, inaccessibility of property information, and danger connected with purchasing properties individually, only the wealthy could enter the market. This comprises institutional investors such as life insurance companies, endowments, and pension funds, in addition to family offices and individuals with an extraordinarily high net worth. DSTs, or Delaware Statutory Trusts, have begun to level the playing field.
Today, DSTs enable individuals to invest fractionally in a trust's assets, which may include one or more pieces of commercial real estate. The sponsor of the DST is then responsible for the day-to-day management of the trust's properties on behalf of the investors.
Moreover, unlike investing in a syndicate or fund, DSTs have been considered "1031 Exchange eligible," meaning that people can sell their own investment property and reinvest the proceeds into a DST to defer capital gains tax. Thus, it is not surprising that DSTs are rapidly gaining favor.
But DSTs did not merely appear suddenly. Their arrival was a lengthy process. This article examines the history and origin of Daylight Saving Time.
The History of DSTs
Historically, wealthy Americans have utilized trusts to transfer property from one generation to the next. Using a trust provides tax and security advantages that would not otherwise be available.
The majority of these trusts are housed in Delaware, a state renowned for being business-friendly and tax-friendly. Since at least 1947, Delaware common law has recognized business trusts. This is why a large number of Fortune 500 firms put their headquarters in the state. Trust income, including capital gains, has been exempt from taxation for decades, even trusts controlled by non-residents. In other words, out-of-state residents can take advantage of Delaware's trust tax laws just as easily as Delaware residents.
In 1988, Delaware formalized its common law on trusts and became the first state to establish an effective and judicially protected legal entity: the Delaware Statutory Trust (DST). The Delaware Business Trust Act of 1988 provides specific guidelines for the operation of trusts. This gave investors the assurance they required to invest with confidence in DSTs.
Several other states have since enacted legislation governing trusts, but Delaware remains the jurisdiction of choice for trustees due to the breadth and clarity of its corporate entity rules. In addition, the Court of Chancery and the Supreme Court of Delaware have gained a reputation for excellence due to their extensive familiarity with commercial matters, which results in the efficient, fast, and equitable resolution of disputes. Today, there is a vast body of Delaware case law from which people seeking trust-related assistance might draw.
The Delaware Business Trust Act (DBTA) was renamed the Delaware Statutory Trust Act (DST Act) in 2002. (Title 12, Ch. 38 of the Delaware Code). The DST Act expressly authorizes the establishment of DSTs and stipulates rules governing their internal operations. The DST Act recognizes DSTs as distinct legal entities that may engage in any legitimate business or activity. The regulations further indicate that a DST will not terminate or dissolve due to the death, incapacity, dissolution, termination, or bankruptcy of a beneficial owner, unless the Trust Agreement specifies otherwise. DSTs are also permitted to obtain funding in their own name as opposed to in the names of their individual trustees.
The DST Act also specifically limits the trustee's obligation. The Act provides that a trustee "must not be personally accountable to any person other than the statutory trust or a beneficial owner for any act, omission, or obligation of the statutory trust or any trustee thereof," unless otherwise expressly stipulated in the trust's governing instruments. This provision provides trustees with great protection; they can rest easy knowing that the possible liabilities they may face as a result of investing in a DST are strictly limited, whereas indemnity affords them extensive protections.
DSTs vs. TICs
The DST Act of 2002 effectively provides the necessary advice and protections for persons interested in fractional investments in commercial real estate. Prior to this, the majority of co-investors in real estate utilized a tenant-in-common (or "TIC") structure.
Those who invest in a TIC hold a partial interest in the property's title. As a result, each owner is personally accountable for any debt incurred to acquire or enhance property held by a TIC. TICs can have up to 35 individual co-owners, therefore the procedure of underwriting each individual investor might make financing a TIC more difficult than financing DST investments, because the loan is backed by the DST itself and not by individual investors.
Moreover, each major investment decision involving TICs requires unanimity among co-investors. Even in the best of times, this makes decision-making difficult. Important decisions required to develop the TIC's business plan and investment strategy can be halted by a single holdout.
Despite the obvious benefits of investing in a DST as opposed to a TIC, many continued to favor the latter until the middle of the 2000s. This is because industry groups, including some of the nation's top commercial real estate sponsors, urged the IRS in the early 2000s to adopt criteria that would allow TIC real estate to qualify for 1031 exchanges (IRS Revenue Procedure 2002-22). Those who sold their own investment property could then reinvest the sale proceeds into a TIC to delay paying capital gains tax (sometimes, indefinitely).
This led to a record number of people investing in TICs. 2007 marked the peak of the TIC business, when about $4 billion of equity was invested using TIC structures. Nonetheless, many of these investors quickly realized the flaws of the TIC framework.
DSTs gained popularity at the same period, partly due to the inefficiencies of the TIC paradigm. The IRS implemented comparable 1031 exchange standards for DSTs in 2004. Revenue Ruling 2004-86 permitted the use of the DST structure for the acquisition of real estate where the beneficial interests of the trust would be recognized as direct interests in replacement property for purposes of a 1031 exchange. Investors in the United States rejoiced.
Co-Investment in Real Estate During the Great Recession
When the Great Recession struck in 2008, both TICs and DSTs suffered a severe blow. The investment in syndicated real estate plummeted. TICs were hit worse than DSTs. In 2009, less than $250 million was invested in TICs, which represents approximately 6.25 percent of the equity contributed just two years previous. In general, lenders grew more prudent. Due to the necessity to evaluate each investor's creditworthiness, a minuscule number of people desired to invest in TICs. The effort required by banks to establish loans on TICs (which, again, might have up to 35 individual investors) simply became too burdensome.
Investment in TICs and DSTs remained stagnant over the most of 2013. As the economy began to recover, DSTs became the favored form for co-investment. By 2015, DST investment had regained its pre-recession level and has risen steadily since then. In 2020, around $3.20 billion in equity was raised for DST investments, a surprising amount given the remaining anxiety among investors caused by COVID.
Future Prospects for DSTs
Investing in DSTs could continue to be robust in the future. There is a backlog of investors who are eagerly awaiting the end of the pandemic before selling their property. Many of these investors may use 1031 exchanges to avoid paying capital gains tax, and many of them may invest in DSTs to do so. Cash investors are diversifying their portfolios by expanding their DST investments. DSTs are a fantastic alternative for accredited investors wishing to invest in fully passive real estate due to the variety of associated potential benefits, including asset and geographic diversity.
Already, it appears that 2021 will be a good year for DST equities investments. This could continue throughout the coming months and years, barring any unforeseen occurrences.
Are you curious to find out more about DSTs? Contact us immediately to learn more about our investing strategy, 1031 exchanges, and DSTs.
Not an offer to buy, nor a solicitation to sell securities. Information herein is provided for information purposes only and should not be relied upon to make an investment decision. All investing involves risk of loss of some, or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing.
Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.
1031 Risk Disclosure:
- * There is no guarantee that any strategy will be successful or achieve investment objectives;
- * Potential for property value loss - All real estate investments have the potential to lose value during the life of the investments;
- * Change of tax status - The income stream and depreciation schedule for any investment property may affect the property owner's income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;
- * Potential for foreclosure - All financed real estate investments have potential for foreclosure;
- * Illiquidity - Because 1031 exchanges are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.
- * Reduction or Elimination of Monthly Cash Flow Distributions - Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;
- * Impact of fees/expenses - Costs associated with the transaction may impact investors' returns and may outweigh the tax benefits