DSTs, TICs and 1031s: Making Sense of Real Estate Ownership Structures

A 1031 exchange allows your clients to sell an investment property and purchase another like-kind property while deferring the capital gains taxes on the sale. It’s a way for clients to retain real estate exposure and keep their capital working for them. 1031 exchanges also give clients an opportunity to enter into a new ownership structure—one without many of the headaches that come with direct real estate ownership, such as managing a property in an inconvenient location or dealing with unexpected expenses.

An investment tactic is exchanging a directly owned property for investment in a shared real estate vehicle, the two most common structures being tenants-in-common (TICs) properties and Delaware Statutory Trusts (DSTs). Both structures allow investors to become joint owners of real estate through a fractional ownership structure. However, DSTs were designed to address certain limitations of TICs, and investors can benefit from the advantages they provide.

“DSTs can offer investors all the benefits they’ve looked for in traditional real estate, including depreciation and reduced tax liability for any tenant improvements or debt service,” says Rob Johnson, head of wealth management for investment property management firm Realized. “But the investors themselves are not taking on that ongoing property management role.”

The limitations of TICs

TICs allow for a maximum of 35 investors. That may sound like a lot, but it’s far fewer than DSTs allow, meaning that each investor is responsible for contributing a large sum of money toward the property. However, if the TIC is leveraged, most lenders will allow fewer investors – likely limiting to single digits – due to the difficulty in obtaining unanimous decision making.

While TICs typically involve less hands-on work than direct ownership, the owners who share the property still have to make a number of management decisions together. And for major decisions, unanimous consent of all co-owners is needed. Coordinating a decision on that scale can make the 35-investor limit feel astronomical.

TICs can also be challenging due to the nature of their shared ownership structure. Since each TIC owner holds title to the shared property, all co-owners must carry a mortgage if the property is leveraged. As each TIC investor is deemed to hold an undivided interest in title, the lender needs to underwrite each individual borrower. If an investor wants to transfer a TIC interest, the lender would have to underwrite each individual investor and then underwrite the prospective transferred and amend all documents accordingly.

All of these factors can make financing hard to come by; some lenders may opt to avoid the administrative complexity of funding a structure with so many co-owners. Plus, TIC co-owners are required to set up an LLC to shield their personal assets in case the TIC faces legal issues or files for bankruptcy. However, there could be debt-free TICS where this does not apply.

The advantages of DSTs

A DST is a legal entity that gives accredited investors a fractional interest in a trust that owns real estate. Unlike TICs, the investors do not share in direct ownership of the property. “A DST allows clients to align their investment with Sponsors that have an established track record of taking projects from investment to full cycle,” Johnson says. “These Sponsors go out and conduct their own research and due diligence on markets, properties and tenants. They have an enormous amount of resources at their disposal.”

DSTs provide an opportunity for truly hands-off real estate investment. All of the property management and decisions will be handled not by the investors, but by the Sponsor and property manager. Plus, the investor limit for most DSTs is much higher than it is for TICs—in the hundreds, instead of 35.

Clients can put less capital into each property they invest in—as little as $100,000, or even less for cash investments—potentially allowing for multiple DST investments and the diversification benefits that come with a less concentrated real estate portfolio. These benefits include geographic diversity, allowing clients to invest in real estate that might not necessarily be near their primary residence.

“When you have diversification, there’s probably going to be one investment that outperforms, one that performs at market and one that underperforms,” Johnson says. “And those will change based on what’s going on in the macro environment. But with that diversification, you’re probably going to end up somewhere in the middle. And that’s a good place to be.”

DSTs also provide significant debt-related advantage. Any debt taken on by a DST is held by the trust and not by the investors. There’s no mortgage for your clients to deal with, and any debt allocated to them is non-recourse. Plus, DSTs don’t require any additional entities to protect investor assets; the trust itself provides those protections.

Benefiting from Sponsor expertise

While DSTs represent an appealing real estate investment option for many clients, not all investors will embrace the hands-off approach it entails. “Clients have to have comfort and confidence in knowing that the Sponsor is going to acquire, manage and decide when to dispose of the property,” Johnson says.

For those who are comfortable with this arrangement, using a 1031 exchange to swap direct property ownership for shared real estate investment in a DST may provide long-term benefits, including diversification and capital growth. And as Johnson points out, alignment with a knowledgeable Sponsor is one of its biggest advantages. “Your client is investing alongside a firm that’s putting together the investment, managing it and deciding on the right time to exit,” Johnson says. “That’s a winning strategy for most clients.”

Full disclosure. The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.