7 Estate Planning Benefits of
Delaware Statutory Trusts (DSTs)

Perhaps one of the most significant advantages of utilizing DSTs in estate planning is the ability to eliminate capital gains tax on inherited property. According to IRS Section 1014(a)(1), beneficiaries inherit assets with a stepped-up basis, meaning that an asset’s tax basis is readjusted to its fair market value at the time of the decedent’s death. As a result, the accrued capital gains, which may have been accumulated over decades, become virtually tax-free for the beneficiaries. The strategy of deferring taxes through 1031 Exchanges until the passing of an owner, which creates a step-up in basis, is a core aspect of many intentional real estate owners’ tax planning.

Step-up in basis example:

1. Owner purchases property with an original cost basis of $500,000
2. Property appreciates to $1.5 million in value by the time of owner’s passing
3. Property is inherited with a stepped-up basis of $1.5 million – the current market value
4. Beneficiary can sell the property at current value with no capital gains tax owed

One of the common hurdles in estate planning is navigating the potential disagreements among beneficiaries, particularly regarding asset management, liquidation, and the distribution of assets. For illiquid assets such as real estate investments, the division becomes even more complicated and prone to disputes.

DSTs offer a solution to these challenges. Instead of leaving assets in a form of ownership that could lead to contention among beneficiaries, investors can leverage DSTs to ensure a proactive diversification and distribution strategy. DSTs are a co-ownership structure, however there is no management responsibility associated with ownership. Ownership can easily be divided and distributed to beneficiaries however the owner intends without forcing a co-management situation. By exchanging fee simple real estate into DSTs, investors can ensure a flexible and efficient division of assets among beneficiaries.

A common goal for many investment real estate owners to make a lasting impact through charitable giving. While the intention is noble, the complexity of donating illiquid actively managed assets, such as directly owned real estate, poses a significant challenge. Many non-profit organizations are simply not equipped to handle direct real estate bequests. Often the organizations are forced to engage outside specialists to evaluate whether accepting of the gift exposes them to liability such as undisclosed environmental or title issues. Once accepted, the properties are commonly sold shortly after receipt, often at a discount to what a more experienced investment real estate owner could realize.

DSTs provide a solution that empowers non-profits and charitable organizations to benefit from a consistent income stream without the need for costly vetting and the challenges of direct real estate ownership. This allows the organization to focus on its core mission without being sidetracked by the intricacies of real estate, such as property management, insurance, and other related issues. Utilizing DSTs can be a win-win solution: it simplifies the gifting process for the investor and recipients. DSTs also allow for a portion of ownership to be gifted as opposed to a property in its entirety.

DSTs can significantly accelerate the wealth accumulation process while simultaneously stabilizing cash flow for investment real estate owners and their beneficiaries. By utilizing 1031 Exchanges, investors can strategically defer taxes, allowing the proceeds from property sales to remain invested and fuel compounded growth. This not only expedites the wealth building process but also maximizes monthly income by ensuring more capital is actively invested.

The flexibility of DSTs also allows investors to diversify beyond traditional real estate investments such as small-to-medium size apartment buildings and single-family homes, providing access to a range of property types, including commercial properties such as industrial or medical office and niche property types such as self-storage facilities. This strategy can lead to robust wealth accumulation and enhanced income potential, providing investors and their beneficiaries a substantial advantage over traditional fee simple ownership.

When an individual passes away, estate taxes are imposed at both federal and state levels on the net value of an estate. Currently, the federal government has a relatively high exemption threshold; only estates surpassing this value are subject to federal estate taxes. However, many states impose estate taxes with significantly lower exemption thresholds, subjecting a far greater number of estates to taxation.

One of the prominent advantages of using a DST in estate planning is the ability to potentially reduce the taxable estate value through two types of discounts:

• Discounts for Lack of Control: Since DST investors do not have direct control over the property or the trust’s decisions, a discount can be applied to the asset’s value for estate valuation purposes. The reduced value is purely for estate valuation purposes and should not be interpreted to mean a true reduction in the asset values from a sale standpoint.
• Discounts for Lack of Marketability: DST interests are not as easily marketable as publicly traded assets. The absence of a readily available market for these interests can further reduce their value for estate tax calculations.
  
  

By strategically utilizing DST investments and leveraging these discounts, investment real estate owners can potentially reduce their estate’s taxable value. Additionally, many states only include real property physically located within the state of residence of the owner in the calculation of their estate value subject to potential state-level estate tax. Acquiring DST real estate outside an owner’s state of residence is another way to mitigate state-level estate tax. These strategies not only ensure more assets are passed down to beneficiaries but can also result in significant tax savings, especially in states with stricter estate tax regulations.

The strategic combination of DSTs with an Umbrella Partnership Real Estate Investment Trust (UpREIT) offers beneficiaries an innovative avenue for enhanced liquidity. By leveraging a 721 exchange, DST ownership can be converted into Operating Partnership (OP) units within a Real Estate Investment Trust (REIT).

Post-conversion, these OP units (which are essentially shares in the REIT with embedded tax deferral inside the shares) can potentially be traded on secondary markets, contingent on the specific terms outlined by the REIT. The liquidity provisions for the OP units potentially grants beneficiaries a method to benefit from the aforementioned step-up in basis and expedite the sale of their inherited real estate holdings to create a liquidity event.

Estate planning becomes even more complex when co-owned assets are involved. A common challenge arises when co-owners of properties have different preferences for distributions: some may wish to cash out, while others prefer reinvesting to defer capital gains taxes, and each will receive step-ups in basis at different times. DSTs address this by facilitating strategies such as the “1031 drop and swap”, where the ownership entity such as an LLC or Limited Partnership is dissolved and the respective members or partners take their ownership directly in their own names or entities such as revocable family living trusts before a sale and 1031 Exchange.

Some entities cannot perform a drop and swap due to the timing of the sale, the position of the taxing authority in which either the property or owners are located or the need for lender consent. In these situations, a “swap and drop” may be an effective solution. In this scenario a property is sold, and each co-owner selects their own DST properties to exchange into, all of which the co-ownership entity acquires. Following the exchange, the entity is dissolved and distributes the specific DST properties the co-owners selected to be owned outright by those individuals.  

The exact mechanics and most appropriate strategy depend on specific circumstances. It is crucial to consult with a licensed 1031 Exchange Advisor to determine whether a “swap and drop” or “drop and swap” is most appropriate for your situation.