Investors looking to invest in real estate without holding direct ownership in a specific property often seek out either Delaware Statutory Trusts (DSTs) or Real Estate Investment Trusts (REITs). Both (DSTs) and (REITs) function as vehicles for investors to access a diversified portfolio of real estate properties, including commercial, residential, or industrial. Investors in DSTs and REITs own shares or interests in a pooled investment vehicle rather than owning properties directly. This indirect ownership allows investors to participate in the income generated by a portfolio of properties without an initial sizeable investment.
DSTS and REITs provide cash flow from rental payments from tenants as well as the potential for equity appreciation. Both distribute a significant portion of their income as dividends and provide a convenient way to gain exposure to the real estate market while bypassing the complexities and management responsibilities associated with direct property ownership. Publicly traded REIT shares are bought and sold on major exchanges, but both private REITs and DSTs can be purchased and sold in private transactions as well.
DST
A Delaware Statutory Trust is a legal entity created under the laws of the state of Delaware. DSTs are used for 1031 exchange purposes and like all 1031 exchanges allowing investors to defer capital gains taxes by reinvesting proceeds from the sale of one property into another like-kind property. However, instead of owing an interest in a specific property, an investor owns units in a trust with other investors.
DSTs typically have a predefined exit strategy or a planned end date. This could be tied to a specific event, such as the sale of the property or the end of the lease term. The life span of a DST is often designed to be long enough to provide stable returns to investors but is not intended to be perpetual.
Investors can, however, perpetually defer taxes by rolling over their existing DST to another DST when their DST closes. Investors can always cash out their investment if they don’t wish to continue deferring taxes through a 1031 exchange. And if willing buyers are available, DST units can be sold incrementally in a taxable transaction while any unsold units can be held for future exchange.
DSTs are passive investments and DST unit holders have no active role or responsibility for property management. Since the properties are typically long-term leased, the income is relatively stable and predictable and generally payable in monthly installment distributions to the unit holders from the trust.
Taxable income from a DST is considered passive, which can have favorable tax implications for certain investors. Investors will continue to benefit from property depreciation deductions, reducing taxable income. Investors do need receive K-1’s, but rather a summary of their portion of income and expenses allocated from the DST.
REIT
A Real Estate Investment Trust is a company that owns, operates, or finances income-generating real estate. Like DSTS, REITs provide a way for individual investors to earn a share of the income produced through real estate ownership without actually having to buy, manage, or finance specific properties.
REITs are actively managed by professionals who make decisions about property acquisitions, sales, and developments. A REIT must be structured as a corporation, trust, or association that is taxable as a corporation. It is typically formed under state law, with most REITs being organized as corporations under the laws of the state of Delaware due to its favorable corporate governance environment.
The REIT must be managed by a board of directors or trustees. The board is responsible for making major decisions, including property acquisitions, sales, and the distribution of income to shareholders. A REIT must be owned by at least 100 shareholders after its first year of existence. No more than 50% of its shares can be held by five or fewer individuals during the last half of the taxable year. This is known as the “5/50 Rule.”
At least 75% of the REIT’s total assets must be invested in real estate assets, cash, and government securities. No more than 5% of the value of the REIT’s assets can be invested in the securities of any one issuer (if not a real estate asset), and a REIT cannot own more than 10% of the voting securities of any one issuer.
At least 75% of the REIT’s gross income must come from real estate-related sources, such as rents from real property, interest on mortgages financing real property, or sales of real estate. Additionally, at least 95% of the REIT’s gross income must come from such real estate sources and dividends or interest from any source.
A REIT must distribute at least 90% of its taxable income to shareholders in the form of dividends each year. These distributions must be made in the same taxable year they are earned or, in certain cases, in the following year if the dividends are declared before the tax return is filed.
Dividends from REITs are generally taxed as ordinary income, though they may qualify for a 20% deduction as qualified REIT dividends. Gains from the sale of REIT shares are subject to capital gains tax. REIT shares do not qualify for 1031 exchanges, limiting tax deferral options.
Comparison
The fixed and stable nature of DST investments tends to result in lower risk compared to REITs. Returns are more predictable due to long-term leases and fixed income structures. DST investments are relatively illiquid, making it difficult to sell interests quickly.
The active management and market exposure of REITs can result in higher risk. Returns can be variable, depending on market conditions and property performance. Publicly traded REITs offer high liquidity, allowing investors to buy and sell shares easily.
Both Delaware Statutory Trusts and Real Estate Investment Trusts provide valuable opportunities for real estate investment, each with its own set of advantages and considerations. DSTs are ideal for investors seeking stable, passive income with tax deferral benefits, particularly for those involved in 1031 exchanges. On the other hand, REITs offer greater flexibility, diversification, and liquidity, making them suitable for investors looking for a more dynamic and actively managed real estate investment.
Investors should carefully evaluate their financial goals, risk tolerance, and investment horizon when choosing between DSTs and REITs to ensure alignment with their overall investment strategy.