Investors in Delaware Statutory Trusts (DSTs) should be aware of the tax implications in various scenarios, including income and capital gains, depreciation, cost basis, and future 1031 exchanges.
A DST structured to qualify as an “investment trust” under Revenue Ruling 2004-86 is recognized by the IRS as a qualified replacement real estate property for Section 1031. Accordingly, a DST is a “grantor trust” that is disregarded for tax purposes, and thereby investors acquiring a fractional interest in a DST are “beneficial interest owners” acquiring a qualified replacement real estate asset for Sec. 1031 despite owning less than 100% of the DST’s property interest. Beneficial owners are treated as having a direct interest in an allocable proportionate share of DST’s real estate and other assets, liabilities, income, deductions, credits, and distributions.
DST Tax Reporting
DST investors own a beneficial interest in an investment trust, which owns a direct fee simple interest in the real estate, and not a partnership interest nor an interest in a corporation. Partnerships and corporations annually issue to their partners or investors Schedule K-1s or Form 1099s that present to each investor their respective distributions, income, deductions, and other tax reporting information. Instead, DSTs annually issue grantor trust letters to their beneficial interest owners. The format of the grantor trust letters may vary among DST sponsors because there is no set format required by the IRS. However, the grantor trust letter should provide the beneficial owner an operating statement detailing their share of rental income and expenses. In some cases, the cash flow income received from the investment may be reported on a substitute Form 1099 and the interest expense reported on a Form 1098. In any case, the investor’s share of income and expenses should in turn be reported on IRS Schedule E of the investor’s annual income tax return or IRS Form 1040. This is similar to the reporting of income and expenses from a single ownership rental property.
At times, a DST’s taxable rental income may exceed the distributions received due to “phantom income” events. One reason for such a phantom income is rents received from tenants in advance. Phantom income may also arise if the DST loan is amortized or if the DST property is cash flowing but cash is insufficient to make distributions. For instance, a DST mortgage lender’s loan terms may provide for suspension of cash distributions (cash traps) upon the occurrence of certain events. In such an instance, the grantor trust letter may report rental income despite the suspension of distributions.
The grantor trust letter will also include the beneficial interest owner’s share of the DST’s business interest expense. Investors should consult with their tax professionals due to the business interest expense limitation brought on by the Tax Cuts and Jobs Act’s expansion of IRC Section 163(j).
Multi-State DST Properties
DSTs comprised of properties located in more than one state may pose additional state reporting filings for each state in which properties are located, dependent upon an investor’s state of residency and the amount of income allocated to the state the property is located after deductions for depreciation and other expenses. In some cases, the net adjusted taxable income may be lower than the state filing requirements due to standard deductions and personal exemptions allowed by the state.
An investor will not find depreciation on the grantor trust letter because depreciation calculations are investor dependent. When a DST investment is used as a replacement property in a 1031 exchange, while the capital gain is not recognized, the investor’s adjusted cost basis from the relinquished property must be carried forward to the new DST property interest. In most cases, the carried over basis will continue to be depreciated under the same straight-line depreciation schedule and the same reminding useful life as it was reported for the replacement property on IRS Form 4562, Depreciation and Amortization.
If the DST properties purchased have a greater value, which is the case if there was an increase in the amount of replacement DST debt over the amount of relinquished property debt in the exchange, this increase in value or debt becomes a new tax basis. The new additional tax basis must be depreciated on a straight-line basis over a new useful life schedule of 27.5 years for a residential property DST or a new useful life schedule of 39 years for a commercial property DST.
Accordingly, unlike a partnership’s Schedule K-1, an investor’s basis information is typically not found in the grantor trust letter. However, information in the grantor trust letter should be provided to help allocate an investor’s acquisition price of the beneficial ownership interest in the DST between non-depreciable land and depreciable building.
Tax Treatment of Future 1031 Exchanges
There is no limit to the number of 1031 exchanges an investor can complete. If a DST investment is successful and the property is sold for a profit, the sale proceeds can be reinvested in another DST offering to extend tax benefits.
While DST syndications are 20 years old and the volume of DST syndications has expanded, many tax practitioners are still not familiar with DSTs and grantor trust letters. Through proactive communication with DST sponsors and professional advisors, beneficial interest owners can navigate the complexities of DST investments effectively and optimize their tax strategies for long-term success.