Wealth Secrets: DSTs, Using 1031 Exchanges & More – Which is Best for Your Real Estate Investing Needs?

Setting aside owning our home, I’ve been investing directly in real estate for about a decade. In my experience, real estate can be a better path to building wealth than stocks. But, that doesn’t mean everyone should invest in real estate or that there’s one real estate option that’s best for everyone.

This article will review the relative benefits and drawbacks of three paths to real estate investing: direct investment in individual properties, Delaware Statutory Trusts (DSTs), and publicly traded Real Estate Investment Trusts (REITs).

The Main Benefits of Real Estate Investing

The biggest advantages of real estate as an investment asset class are:

• Leveraged appreciation: In almost all cases, you finance real estate purchases with mortgages, which lets you benefit from the full appreciation of your properties while investing a small fraction of the total value. For example, if you pay 20% down and the asset appreciates the typical 5% a year, your return will be that 5% multiplied by your 5× leverage, or 25% (less your interest cost, which may be as low as 3% or possibly much higher). This is often far better than the ~10% average stock market returns.
• Tax advantages: Your appreciation is taxed only when you sell, and even then, it’s taxed at preferred capital appreciation rates rather than regular income rates. Further, you can use depreciation to reduce your tax liability for, e.g., rental income and/or even wage income. Finally, if you use §1031 exchanges, you can defer capital gains taxes potentially forever (through step-up basis when you leave the asset to your heirs).
• Passive income: If you hire a property manager, a rental income property provides passive income.
• Diversification: If most of your wealth is in stocks and bonds, real estate is an effective diversification tool.
• Inflation hedge: Real estate has historically performed well in high-inflation periods, as property prices and rents tend to go up with inflation.

The Main Drawbacks and Risks of Real Estate Investing

Along with its significant benefits, real estate investing does have its drawbacks. For example:

• Low accessibility: If you invest directly in individual properties, the minimum investment amount is often the down payment plus other closing costs, which can be multi-six figures or more.
• Low liquidity: Buying and selling real estate takes a great deal of knowledge, due diligence, and time. If you want to draw money out, the process can take months or longer in most cases.
• Leveraged losses: Just as leverage works to your advantage when your property appreciates, it works against you when it loses value. For example, if you use 5× leverage and your property’s value decreases by 20%, your equity can drop to zero.
• Active management: If you prefer to avoid paying for property management services, managing your properties can become a full-time job.
• Limited diversification: Since real estate investing takes a lot of capital, your portfolio of properties will likely be limited, making you more subject to locale-specific or even property-specific fluctuations.
• Impact of vacancies: If your rental property sits empty, you have to continue covering the carrying costs (mostly mortgage, insurance, and tax payments) without any income to offset these.

Comparing Direct, DST, and REIT-Based Real Estate Investing

The following table summarizes the relative benefits and drawbacks of three paths to real estate investing: direct investment in individual properties, Delaware Statutory Trusts (DSTs), and publicly traded Real Estate Investment Trusts (REITs).

Are Individual Properties a Good Option for You?

As the table shows, direct investment in individual real estate properties offers many benefits of real estate investing but suffers from some significant drawbacks and limitations.

Specifically, you have complete control over investments (within the limitations of what the market offers that you can invest in), transparency, diversification relative to the stock market, low fees (unless you hire a property manager), and most real-estate-related tax benefits.

On the flip side, you need a good deal of capital for each property, which makes it difficult (i.e., expensive) to access institutional-grade assets and/or diversify across properties. Investment minimums are high, liquidity is low, hiring a property manager can be expensive (e.g., for residential rentals, a property management company charges 6–8% of rent), real estate agent commissions can add up, and you may be hit with big capital-gain spikes (see below) that could cost you a lot.

This could still be a good option for you if:

• You enjoy active involvement in picking properties, marketing rentals, selecting tenants, dealing with tenants, handling maintenance and repairs, and overseeing operations.
• You have expertise in the real estate market and property valuation, rent regulations, and property management practices.
• You have access to significant capital and financing for purchasing properties and reserves for covering expenses, especially when properties are vacant.
• You’re comfortable with the risks associated with real estate investing and the drawbacks and limitations of such a portfolio.
• You have a significant stock and/or bond portfolio that lets you benefit from the diversification of real estate.
• Your ongoing income is high, so the tax advantages of real estate offer significant benefits.

Are REITs a Good Option for You?

As you can see in the above table, REITs address many of the drawbacks of direct investments and DSTs. Specifically, they allow you to invest in institutional-grade assets, and have high diversification, high liquidity (you can sell REIT shares whenever the stock exchange on which they trade is open), high accessibility (i.e., low investment minimums), passive income, and moderate fees.

However, you lose some of the biggest advantages: no control over asset selection, minimal transparency, diversification relative to the stock market, tax deferral, taxation at capital-gains rates, and depreciation.

REITs are a good option for you if:

• You need lower investment minimums.
• You want high diversification across properties (but don’t need diversification with respect to the stock market).
• You need high liquidity.
• Taxation isn’t a major concern, given your overall financial situation.

Are DSTs the Best Option for You?

Investing in one or more DSTs offers many of the same benefits as direct investing in individual properties and addresses some of the drawbacks of such direct investments.

However, it has its own drawbacks and limitations.

You can get access to institutional-grade properties and diversification across property types, locations, and tenants (diversification requires investing in DSTs that hold a basket of properties). 

You avoid the need for hands-on involvement in picking and managing properties (you do need to pick DSTs, which can be single-property DSTs) and renters. You get the same tax advantages as direct investing, and better yet, you can use §1031 exchanges into multiple DSTs to avoid capital-gains spikes. 

You can even take advantage of “swap until you drop” rollovers to defer capital gains until you pass away, at which time your heirs will benefit from a basis step-up, avoiding capital gains tax altogether on your gains.

However, no investment avoids all drawbacks and DSTs are no exception.

DSTs are illiquid and you typically have to be able to leave your capital invested until the underlying investment properties are sold, potentially up to 3–7 years. 

Investment minimums are high (typically $100k or more), you need to be an accredited investor, and you need to invest through an advisor to have access. 

Finally, DSTs holding a basket of properties give you limited (or no) control over picking individual properties, and all DSTs offer more limited transparency than direct investments and higher fees (unless you hire a property manager).

DSTs, especially through §1031 exchanges, tend to benefit you most if:

• You’re looking to sell one or more investment properties and reinvest in real estate to defer capital gains tax.
• You can afford the relatively high minimum investment but don’t want to (or can’t) invest so much that you can diversify direct investments across property types, locations, and tenants.
• You have a large enough stock and/or bond portfolio to benefit from real estate exposure.
• You have a high enough income to benefit from the tax advantages of real estate investing.
• You’re looking for a hands-off real estate investment, without the responsibility of picking properties and renters and/or managing operations.
• You’re interested in using real estate investing as part of your estate planning.

A Deeper Dive into the Tax Benefits of DSTs, 1031 Exchanges & More

If you already invest directly in individual properties, you’re likely enjoying the tax benefits mentioned above. However, you may be unaware of the ever-deepening tax pit you’re approaching. 

Jacob T. Rothman, CPA, CFA, CFP®, Portfolio Manager, Rothman Investment Management explains, “Selling an investment property you’ve held for a long time can subject you to crushing taxes:

• “Your capital gain is taxed in a single year, likely pushing you into the highest relevant tax brackets (potentially including the highest bracket of state income taxes).
• “You’re likely subject to Medicare Net Investment tax.
• “All the money you saved by depreciating over the years and decades gets clawed back through depreciation recapture at a 25% rate.
• “If you’re covered by Medicare, you may be subject to the Income Related Medicare Adjustment Amount (IRMAA), an income-based surcharge for Medicare participants that could amount to thousands of dollars a year.

“To avoid all this, you can roll your cost basis into a replacement property using a §1031 exchange, deferring all gains except for any “boot” you received. Note that the IRS safe harbor for §1031 exchanges requires you to hold your original property as an investment property for at least two years before the exchange and hold the replacement property as an investment property for at least two years after. DSTs thus always keep your money locked up for at least two years, as would any other replacement property. 

“However, buying a replacement property doesn’t let you get away from actively managing your investments and properties. You also have only 45 days to identify the replacement property and 180 days to close the sale, and the property needs to have a high enough value to offset your full proceeds. DSTs provide a complete answer to these limitations, albeit subject to the above-mentioned drawbacks.”

DSTs may offer higher yields than direct investments and can serve as a backup replacement property to avoid “busted 1031 exchanges” where you can’t find an appropriate like-for-like property you want and close the purchase within the statutory time limits.

Most importantly, by spreading your capital across multiple DSTs, you can realize gains gradually over time, avoiding capital-gains spikes that could cost you dearly. Note that doing this requires you to invest multiples of the $100k minimum (one per DST), which shouldn’t be a problem if you’re selling a highly appreciated property.

Which is Right for You: DST, REIT, or Direct Real Estate Investing?

Ultimately, the answer as to which real estate strategy is best for you, direct investing vs. REITs vs. DSTs, comes down to your specific investment goals, risk tolerance, expertise, liquidity needs, willingness to actively manage properties, and tax considerations. The above tries to detail the pros and cons of each approach, and who’s most likely to benefit most from each.

Given the complexity and potential (positive and negative) impacts of real estate investing in general and DSTs in particular, you should consult with tax and financial professionals to choose your best path.

Disclaimer: This article is intended for informational purposes only, and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.

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Disclaimer: This article is intended for informational purposes only and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.

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