Utilizing DSTs as a wealth transfer strategy for clients

Financial Professionals may often recommend a Delaware statutory trust (DST) to clients who own investment property and are considering a 1031 exchange. As an investment structure that satisfies "like-kind" replacement property requirements of Internal Revenue Code 1031, the DST has become increasingly popular among 1031 exchangers for the unique benefits it can provide.

A few of those benefits include owning institutional-quality properties, passive property management, and portfolio diversification across property types and geographies. Yet, one valuable characteristic of the DST that is often overlooked is its role as an estate planning tool. This case study will help illustrate the power of this benefit.

Dan was a successful petroleum engineer who has owned investment properties throughout his career. A tax-savvy investor, Dan has efficiently used the 1031 exchange many times over the years to defer capital gains and depreciation recapture taxes on his properties.

Now, well into retirement, Dan has tired of managing his investment properties and wants to transfer ownership to his four children. So, he contacts his long-time investment advisor, Steve, and asks for his advice. Steve presents two options for Dan to consider.

Option #1

Dan adds his four children to the title on each investment property, giving them co-ownership rights immediately. However, disputes among the children arise about whether to keep or sell the properties. To preserve family unity, Dan sells the properties at a market high for a price of $5 million and splits the proceeds equally among himself and his four children.

Knowing they will be responsible for capital gains taxes, Dan starts the arduous and expensive task of tracking the cost basis of each investment property he has owned and sold using a 1031 exchange. After several weeks of effort, he discovers that his original cost basis is $1 million, meaning his children collectively owe long-term capital gains tax on $5 million of appreciated property value.

As high-earning professionals, Dan's children will be responsible for a 20% capital gains rate and possibly 3.8% net investment income tax, pushing the tax obligation for each close to $240,000.

While the tax hit is painful, this approach does accomplish Dan's goal of divesting his real estate (or the "proceeds from the sale of his real estate") equally among his children.

Option #2

Dan sells his properties using a 1031 exchange, reinvests the proceeds in a DST, and adds his children to his will with equal ownership of the DST upon his death. This strategy allows Dan to defer capital gains tax and still own income-producing properties that require no active management and will ultimately pass to his heirs. So, this solution also accomplishes Dan's objectives, but with another significant benefit.

Under current law, the cost basis on inherited property receives a "step-up" in basis to fair market value upon the owner's death. That means Dan's children are exempt from paying capital gains tax on Dan's investment properties' appreciated value over the years.

And since each of Dan's heirs own an equal fractional interest in the DST, they can decide what to do with their investment. For example, when the properties in the DST sell, one or two of Dan's children may choose to liquidate and use their funds for other purposes. In contrast, the other children may reinvest in a new DST and continue deferring capital gains on their investment.

Given the two options, the decision was relatively easy for Dan. As an investor who was always attuned to the tax impact on investments and wealth creation, Dan opted for the DST strategy.