Today’s investors have started turning to real estate investment trusts (REIT) and Delaware Statutory Trusts (DST) as alternatives to real estate investing. Each option offers a unique opportunity to enjoy the benefits of owning real estate – without the hassle of managing the property.
Although both options are considered real estate investment alternatives, they differ in specific ways. Investors who are currently or considering investing in one of these alternatives should understand the differences, the tax implications, and the potential impact on their investment portfolio.
Real Estate Investment Trusts (REIT)
“A real estate investment trust, or REIT, is a corporation that owns and/or manages income-producing commercial real estate. When individuals buy a real estate investment trust share, they are purchasing a share of the company that owns and manages the rental property.” This is known as an equity REIT.
“Most [equity REITs] focus on a specific product type (e.g., retail, hospitality, multifamily housing, senior living facilities, student housing, office space, self-storage, industrial, and so on) or geography (e.g., commercial real estate in the Northeast vs. Southwest).”
In addition to equity REITs, which invest in and manage income-producing property, are mortgage REITs and hybrid REITs. A mortgage REIT holds a mortgage on real property, while a hybrid REIT holds mortgages and owns property.
To be considered a REIT, a company must follow strict guidelines. The REIT must be an entity that is taxable as a corporation and must be managed by a board of directors or trustees. It must invest at least 75 percent of total assets in real estate, cash, or U.S. Treasuries, and derive at least 75 percent of gross income from rent or real estate sales. Mortgage REITs derive income from interest on mortgages that finance real property.
After its first year of existence, the company must have at least 100 shareholders, and five or fewer individuals must hold no more than 50 percent of its shares.
Companies that file as REITs can avoid triple taxation by distributing at least 90 percent of their taxable income to shareholders, which results only in double taxation. The 10 percent not distributed to investors can be reinvested to acquire new properties for the portfolio.
Types of REITs
REITs can be publicly traded, non-traded, or private. The first two – publicly traded and non-traded – must register with the Securities and Exchange Commission (SEC). The major difference between these two is that publicly traded REITs are listed on a national securities exchange, offering retail investors direct access to trades. In contrast, non-traded REITS are not—investors looking for an investment that is not typically subject to stock market fluctuations generally select non-traded REITs.
Private REITs, on the other hand, are not registered with the SEC and are not publicly traded. These REITs are generally restricted to institutional investors.
Delaware Statutory Trusts (DST)
“A Delaware Statutory Trust, or DST, is a legally recognized real estate investment trust in which investors can purchase ownership interest. Investors who own fractional ownership are known as beneficiaries of the trust – they are considered passive investors.” The trust is initially created by a sponsor, who is responsible for identifying and acquiring the various real estate assets. The DST sponsor is generally a professional real estate individual or company.
“Properties held in DSTs that are considered ‘like-kind’ include retail assets, multifamily properties, self-storage facilities, medical offices, and other types of commercial real estate.”
As investors contribute to the DST, their capital replaces the initial capital used by the DST sponsor until the investors become the owners of the real estate. Unlike a REIT, where investors own a share in the company, a DST offers them direct real estate ownership.
Holding Period and Exit Strategy
Both non-traded REITs and DSTs generally require investors to hold the asset for a minimum of five years. Investors looking to liquidate prior to this may incur difficulty or additional fees.
Non-traded REITs, for example, often allow investors to sell back shares at select intervals after the second year; however, investors who select this option tend to receive only a portion of their initial investment in return. To attempt to maximize returns on REITs, it can be best to wait until the REIT changes – via a merger, outright sale, or listing (goes public).
Since DSTs offer fractional ownership, those who invest in these trusts can only liquidate their portion by selling their fractional ownership themselves or when the DST sponsor sells the asset, historically after 5-7 years. If the investor wishes to sell their share themselves prior to a sale of the property by the DST sponsor, they should understand that there is no secondary market for these trades; rather, investors usually work with a qualified professional to attempt to help identify a suitable buyer.
Generally speaking, to seek to maximize returns on DSTs, it can be best to wait until the DST has reached full cycle, meaning it has been sold on behalf of investors by the DST sponsor. At that time, investors can opt to cash out and receive any returns from their investment or trade via a 1031 exchange.
It’s important to note that there are alternative exit strategies for a DST, although the aforementioned is the most common. For example, in some circumstances, an investor could utilize a section 721 exchange to trade fractional ownership in a DST for shares in a REIT, allowing the investor to defer capital gains.
Tax Advantages of REITs vs. DSTs
All income generated from REITs and DSTs is taxable. However, each investment is taxable in different ways.
Tax Treatment of REITs
Dividends received from REITs – which are usually paid monthly or quarterly – are taxed at different rates depending on how the income is categorized. Most dividends paid come from a REIT’s taxable income. Therefore, investors are taxed at their marginal tax rate. When a property in the portfolio is sold, however, an investor may receive capital gains distributions, which incur preferential tax rates since they are treated as capital gains.
Another way investors can receive distributions is related to return of capital – this includes distributions that exceed a REIT’s profits. Investors are not immediately taxed on this income; taxes are deferred until the investor sells their shares.
Distributions are categorized on a standard 1099 form, which every investor receives from the REIT for tax purposes.
Additionally, per the 2017 Tax Cuts and Jobs Act, REIT investors can also claim a 20 percent deduction on pass-through income until the end of 2025. This allows investors to deduct 20 percent of taxable REIT dividend income, excluding anything that qualifies for the capital gains rate.
Tax Treatment of DSTs
Like a REIT, income from DST dividends is taxed as ordinary income. Therefore, investors are taxed at their marginal tax rate. Fractional owners receive a 1099 form that outlines their pro-rata ownership of income and expenses from the DST assets.
Since DST investors are real estate owners, they can also benefit from depreciation, unlike REIT shareholders. Additional deductions may also be included.
Once the properties in the DST are sold, investors are responsible for paying capital gains. However, DSTs are unique in that they qualify for a 1031 exchange. A 1031 exchange, or a “like-kind” exchange, “represents a simple, strategic method for selling one property and exchanging it for one or more like-kind properties within a specific time frame.
The Internal Revenue Service [IRS] allows an investment property owner to exchange the real estate on a tax-deferred basis. In other words, investors defer paying capital gains through a 1031 exchange, which often equals 20 to 30 percent of their gains.”
Any investor considering selling their shares in a REIT or their ownership in a DST should consult with a certified public accountant (CPA) to understand the full tax implications.
Where to invest: A REIT or a DST?
Investments in REITs and DSTs provide individuals access to unique real estate opportunities. Those looking to replace existing real estate via a 1031 exchange should consider investing in a DST, whereas those looking to place cash have the flexibility to select from the two.
To better understand which options are best suited for your investment strategy, you should speak with a qualified professional about current investment opportunities.
Not an offer to buy, nor a solicitation to sell securities. All investing involves risk of loss of some or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing. Any information provided is for informational purposes only.
Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.
1031 Risk Disclosure:
· There’s no guarantee any strategy will be successful or achieve investment objectives;
· All real estate investments have the potential to lose value during the life of the investments;
· The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;
· All financed real estate investments have potential for foreclosure;
· These 1031 exchanges are offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.
· If a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;
· Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits