1031 Exchange Into a DST: Pros, Cons & My Experience

Thinking about selling a rental property but dreading the idea of buying and managing another one? A Delaware Statutory Trust (DST) might be worth considering.

In 2022, my husband and I sold an appreciated rental property in Montana and completed a 1031 exchange to defer the capital gains taxes.

We had a decision to make: buy more rental properties or invest in a Delaware Statutory Trust (DST)?

We researched both options, learned a lot about DSTs, and ultimately purchased two replacement properties instead.

But that experience showed me why DSTs can be a valuable tool for certain real estate investors, especially those who are ready to retire from being landlords.

Here's what we learned, why we passed on a DST, and when I think they're worth considering.

What Is a DST in a 1031 Exchange?

A Delaware Statutory Trust (DST) allows multiple investors to own fractional interests in professionally managed real estate, such as apartment complexes, medical buildings, industrial properties, or student housing.

Certain DST interests qualify as replacement real estate for a 1031 exchange, allowing investors to defer capital gains taxes when selling an investment property.

Instead of managing the property yourself, a professional sponsor oversees operations. After expenses and fees, investors may receive distributions from rental income.

Essentially, you're still invested in real estate, but someone else handles the day-to-day headaches.

And if you've ever owned rental property, you know that passive income is sometimes passive only for tax purposes!

Between maintenance calls, tenant issues, unexpected repairs, and setting aside money for improvements, owning rental property can require plenty of time and money.

The Biggest Benefits of Using a DST for a 1031 Exchange

1. Truly Passive Real Estate Investing

This is probably the biggest attraction, particularly for our older clients.

Many have owned rental properties for decades. They've built substantial equity, but they're tired of managing tenants, dealing with repairs, and maintaining aging buildings.

A DST can allow them to sell their property, defer capital gains taxes through a qualifying 1031 exchange, and remain invested in real estate without personally managing it.

2. A Solution for Leftover 1031 Exchange Funds

This is where I think DSTs can be especially valuable.

Let's say you sell an investment property for $800,000 but find a replacement property for only $650,000.

What happens to the remaining $150,000?

If you receive those proceeds rather than reinvesting them in qualifying replacement real estate, you could face a tax bill.

A DST may provide an opportunity to invest those remaining exchange funds and potentially defer additional capital gains taxes.

You can even combine traditional replacement properties and DST interests within the same 1031 exchange, provided all the exchange requirements are met.

3. DSTs Can Help With Debt Replacement

One of the trickier parts of a 1031 exchange is dealing with existing debt.

Generally, to fully defer your gain, you need to purchase replacement property of equal or greater value and reinvest all your equity. Replacing debt is often part of that equation, although additional cash can offset debt relief.

Some DSTs already have financing in place. Your share of that debt may count toward your replacement property value without requiring you to personally apply for a new mortgage.

That's a significant convenience, especially for investors who don't want another mortgage application process.

The Downsides of DST Investing: A Client Experience

DSTs aren't risk-free, and due diligence is absolutely essential.

We had a client who invested in a DST involving property in a college town shortly before COVID hit.

The expectation was strong occupancy and consistent rental income.

Then COVID happened.

What was expected to be a high-occupancy investment quickly experienced vacancies, and the investor couldn't simply sell their interest and move on.

That's one of the biggest drawbacks of DSTs: your money is generally tied up for years.

Many DST investments anticipate holding periods of approximately 5–10 years, although actual timelines vary and are not guaranteed.

Unlike owning your own rental property, you typically can't decide to sell when circumstances change.

And not all DSTs are created equal.

Before investing, pay attention to:

• The property and location: Is there too much dependence on one employer, university, or industry?

• The sponsor and management team: What's their experience and track record?

• Fees and expenses: What are you paying upfront and throughout the investment?

• Liquidity: How long might your money be tied up?

• Income projections: What assumptions are behind the expected distributions?

DST distributions aren't guaranteed, and investments can lose value. Understanding the risks is just as important as understanding the tax benefits.

Why We Didn't Choose a DST for Our Own 1031 Exchange

After researching our options in 2022, we decided a DST wasn't the best fit for us.

We found two replacement rental properties that met our investment goals.

More importantly, we weren't ready to give up control or tie up our investment for several years.

We wanted the flexibility to sell a property if it wasn't working out.

At this season of our lives, we're also comfortable owning rental properties, working with a property management company, and setting aside funds for maintenance and improvements.

That doesn't mean we'll always feel that way.

As we get older and our real estate goals change, a DST may become a much more attractive option.

And that's really the point: the right investment strategy today may look completely different ten years from now.

Is a DST Right for Your 1031 Exchange?

I think DSTs deserve a closer look if you're:

• Ready to retire from managing rental properties.

• Selling an older property that requires increasing maintenance.

• Struggling to find a suitable replacement property within your 1031 exchange deadlines.

• Looking for a way to invest leftover exchange funds.

• Interested in professionally managed real estate without the day-to-day responsibilities.

Keep in mind that most DST offerings require investors to meet accredited investor qualifications, and a DST isn't necessarily appropriate just because it offers tax deferral.

Final Thoughts: Don't Let Taxes Make the Decision for You

One thing our own 1031 exchange reinforced for me is that tax savings should support your investment strategy, not dictate it.

A DST might be an excellent solution if you're ready to be done with tenants, maintenance, and property management.

Or, like us in 2022, you may decide that owning replacement properties directly makes more sense.

The important thing is understanding your options before selling, because 1031 exchanges have strict deadlines and requirements.

This article is for educational purposes and is not individualized tax, legal, or investment advice. DST investments involve risks, including illiquidity and potential loss of principal. Consult your tax and investment professionals before making a decision.