The Journey of a DST Syndication: “Going Full Cycle”

Kivo Daily Staff

Investing in real estate has long been regarded as a lucrative avenue for accumulating wealth and securing financial stability. Specifically for those seeking to defer capital gains taxes through the 1031 exchange, Delaware Statutory Trusts (DSTs) have emerged as a compelling option. Trawnegan Gall, a licensed General Securities Representative with extensive experience in Delaware Statutory Trust investments, provides insights into what happens when a DST syndication goes full cycle.

The Life-Cycle of a DST Syndication

Before we embark on the journey of a DST syndication going full cycle, it’s essential to understand the fundamental concept of DSTs. DSTs are a structure of real estate ownership allowing investors to acquire fractional ownership in institutional quality, income-producing properties. The primary allure of DSTs lies in their being considered “like kind” property for the purpose of 1031 exchange. The large majority of DST investors come in via 1031 exchange and will likewise conduct a follow-on exchange when the program goes full cycle.

The stages of a DST syndication start with the initial setting up of the DST by the sponsor. Each DST is unique and registered in the state of Delaware according to Delaware statutory law, and each DST has both a signatory and Delaware trustee. It is the signatory trustee, an affiliate of the sponsor, who will make the key decisions regarding the property over the hold period. The DST then acquires the property(ies) which is the economic engine of that DST investment. Then the sponsor seeks to raise the capital component of the offering, mostly from 1031 exchangers who invest their relinquished property sale proceeds into the DST. Once the capital raise is complete the DST closes to new investments and enters the hold period, the period when the property is managed for the purpose of providing income and appreciation to investors. While most DST properties project income and appreciation, performance varies significantly depending upon market conditions and myriad other factors, and DSTs have a variety of different emphases; cash flow, appreciation, high LTV “zero coupon” DSTs, etc.

“Going Full Cycle”

When a DST syndication approaches completion, which is when the property(ies) are sold and which is called going “full cycle”, the first step is the sponsor’s notification to the DST interest holders. This notification communicates the projected close date and key details of the impending sale of the property held within the DST. Better sponsors will also provide a detailed disposition analysis at this time, informing the investors what their projected equity proceeds from the sale will be as well as their pro-rata debt and projected total return and IRR from the investment. At this point the interest holders are presented with an important decision: they must choose between completing a follow-on 1031 exchange or receiving the sale proceeds directly, which would incur capital gains tax liability. Most of those who exchanged into the DST originally as well as a good number of the cash investors will choose to do a follow-on 1031 exchange.

Completing a “Roll-Over” 1031 Exchange

For those who opt to do a “roll-over” 1031 exchange, they will provide the contact information of a qualified intermediary (QI) to the closing agent of the seller of the DST property to handle this upcoming exchange. Importantly this “roll-over” exchange will be the same in every respect as a normal exchange. The sale proceeds are sent to the qualified intermediary, the 45 Day and 180 Day deadlines are in full effect as are the identification rules, and when the replacement property(ies) has been selected, it will be purchased by the qualified intermediary as in any exchange. DST investors can exchange into another DST or into any other qualifying “like kind” property.

Disposition Analysis and Sale Loan to Value

While the total return and IRR of a DST investment are critical in terms of the success of the investment, from a 1031 exchange perspective the most important piece of information in the disposition analysis and closing statement is the loan to value of the roll-over exchange. Keep in mind that the exit LTV of a DST will not be the same as that when it was entered. Appreciation or depreciation, amortization of loan principal and closing costs will all affect exit LTV. Appreciation and loan amortization will decrease LTV from the initial level, while underperformance (depreciation in the value of the property) will result in a higher LTV than what it was initially. Knowing the LTV of the roll-over exchange is critical to properly plan and choose a suitable replacement property(ies). Because sponsors will not provide tax advice and because closing statements can be complex, professional tax advice is recommended to calculate the exact exchange LTV. But the two key components are net equity proceeds and the exchangers pro-rata share of the mortgage, if any, paid off at the time of close, with most closing costs being deductible expenses.

When an exchanger is considering a DST replacement property, it must consider what the exit might look like. If they have a high LTV exchange, they must invest in a high LTV DST or add cash to the exchange. But if an investor does not need a high LTV replacement property, they should be wary of investing in one with high debt or without amortization of loan principal. Barring significant appreciation, choosing a high LTV DST up front will usually result in a high LTV roll-over exchange upon the conclusion, and in a worst-case scenario, the investor may need to handle an even higher LTV exchange because of the underperformance of the initial DST. While taking on some debt to increase the basis and obtain additional tax shelter is ordinary and reasonable, exchangers should take on only a little obligation that is not required for their exchange. Experience exchangers realize that a series of 1031 exchanges should not be viewed as a sequence of isolated unrelated events but rather as a progression of related events over time. Specifically, the debt of the first exchange will affect the obligation of the following exchange and so on.

The Closing and Distribution of Proceeds

Upon the close of the DST sale, the proceeds are distributed to the interest holders either through their QI or directly to the account of their choosing. To facilitate transparency and accountability, the sponsor provides a sale closing statement to each interest holder. This statement is a transaction record, ensuring all parties know the financial details.

At this juncture, the investment in the DST is effectively concluded. The interest holder must now act upon their earlier election. They can either proceed with their follow-on exchange, receive the sale proceeds, and pay capital gains tax liability.

Post-Close Distributions

It’s worth noting that many DST sales include post-close distributions. These distributions typically represent the return on reserves held during the investment period. While these funds may take several months to materialize, they are generally of a small magnitude. Importantly, these post-close distributions are usually directed to the regular account where previous distributions have been sent rather than to the QI.

The journey of a DST syndication going through a complete cycle is a multifaceted process that requires careful planning and informed decision-making. The guidance of experts like Trawnegan Gall can prove invaluable in navigating the complexities of DST investments. DSTs offer investors a unique opportunity to defer capital gains taxes, and understanding the intricacies of an entire cycle is pivotal to maximizing the benefits of this investment vehicle.

If you are interested in learning more about DSTs, 1031 exchange, and the services provided by Cornerstone, Mr. Gall can be reached via email at trawnegan@cornerstoneexchange.com or by phone at (714) 939-1039. He eagerly anticipates your inquiries and is prepared to provide you with the answers you seek.