Delaware Statutory Trusts have gained in popularity as a solution for real estate investments – particularly in the world of 1031 exchanges. One of the core benefits of DSTs is their utilization of non-recourse debt, offering investors a range of advantages that may help amplify their investment potential and minimize risk.
Understanding DSTs and 1031 Exchanges:
Before delving into the nuances of non-recourse debt, it’s important to understand the fundamentals of DSTs and 1031 exchanges, so we’re going to double click here for a second. IRC Section 1031 allows investors to defer capital gains, net investment income tax, and depreciation recapture by:
- acquiring one or more replacement properties that are equal to or greater than the value of the relinquished property sold (net sale price),
- reinvesting all the net cash proceeds (net equity) received from that sale, and
- replacing the amount of debt (if any) paid off on the sale of the relinquished property with new debt or with an equal amount of additional out-of-pocket cash.
DSTs, structured as “off-the-shelf”, securitized real estate products, offer a streamlined and simple solution for accredited investors needing to fulfill that debt replacement obligation, while accessing a multitude of institutional quality real estate in almost any type of asset class.
Assuming the non-recourse debt often found within a DST offers several advantages over attempting to secure a loan individually. Let’s explore why:
The Loan:
The structure of the DST is somewhat of a complicated topic – something to potentially go through at another time. To simplify things, the bank loan that the DST sponsor may put on a property is assumed by the investors in the DST because they are beneficial interest owners. This allows the investors to also assume all the benefits while not being responsible for applying for the loan, qualifying for the loan, etc. Investors are simply assuming the loan to value (LTV) in the DST.
Liability:
The primary benefit of non-recourse debt in DSTs is that investors are not personally liable for the repayment of the loan; the DST sponsor is. In the event of default or foreclosure, the lender’s recourse is limited to the collateralized property itself. This safeguards investors’ personal assets and invested principle from being seized to cover any shortfall in repayment. This liability protection enhances investor confidence and mitigates risk, enabling investors to engage in real estate transactions with greater peace of mind.
Leverage:
Utilizing debt (in general) allows investors to amplify their purchasing power and acquire larger, higher-value properties than they could not afford solely through pure equity purchases. This is no different for non-recourse debt. The leverage increases potential default risk, but it also helps to magnify potential returns by allowing investors to benefit from any property appreciation and cash flow without sharing the upside with the lender. Additionally, leveraging non-recourse debt enhances portfolio diversification and optimizes investment strategies.
Tax Benefits:
Now, we’re not tax pros so understand that you should speak to your CPA about this kind of thing, but non-recourse debt in DSTs generally helps investors unlock significant tax advantages, particularly through depreciation. Depending on the asset class of the DST, investors can access a new depreciation schedule, enabling them to offset taxable income and realize substantial tax savings. This tax-efficient strategy is designed to enhance cash flow and overall investment returns, making DSTs an attractive option for tax-conscious investors seeking to optimize their real estate portfolios.
Again, talk to your tax pro about it!
Other Considerations:
While the potential benefits of non-recourse debt are clear, investors must exercise diligence and caution when engaging in DST investments. Participating in a DST entails giving up direct control over the property and decision-making to the sponsor, necessitating trust in their expertise and judgment. Additionally, DSTs are subject to certain limitations, such as the inability to refinance or renegotiate debt terms, highlighting the importance of thorough due diligence and consultation with qualified advisors, like us.
Conclusion:
Non-recourse debt has amazing potential benefits when considering DSTs, offering investors the ability to maximize leverage opportunities, and tax benefits in the form of depreciation, while minimizing administrative burden and personal liability. This makes DSTs an attractive option for investors seeking to optimize their real estate portfolios and achieve their financial objectives. However, it is essential for investors to weigh the advantages and disadvantages carefully with a DST advisor before diving in headfirst. Please do not hesitate to reach out with questions for educational purposes, or to take the next step in investing.