Updated · Part of the CRE investment glossary
How a DST works
A sponsor forms the trust, has it buy a property (often with a loan already in place) and sells beneficial interests to investors. The trustee holds title, collects the income and distributes the cash. Investors own a fractional beneficial interest; they do not vote on leasing, financing or a sale.
Because the trustee may not sign new leases, many DSTs lease the whole property to a master tenant — often affiliated with the sponsor — which then leases space or units to the occupants and runs the building. The trust receives the master lease rent and pays it out.
Interests are usually sold as securities in private placements to accredited investors, with a private placement memorandum describing the property, the loan, the fees and the risks.
Why a DST works for a 1031 exchange
Section 1031 defers gain only when real property is exchanged for real property of a like kind. An interest in a partnership or LLC does not qualify. In Revenue Ruling 2004-86 the IRS looked at a DST holding one leased property and held two things: the trust is an investment trust under Treasury Regulations §301.7701-4(c), classified as a trust rather than a business entity; and because it is a grantor trust, each owner is treated as owning an undivided fractional interest in the real estate.
So a taxpayer who sells a property through a qualified intermediary and buys a DST interest is exchanging real property for an interest in real property — and, if the other requirements of §1031 are met, recognizes no gain. The usual exchange deadlines still apply: 45 days to identify replacement property and 180 days to acquire it.
The limits on the trustee
The ruling depends on the trust being passive. In the ruling the trustee may not accept new contributions, may only invest cash between distributions in short-term government obligations or certificates of deposit, and must distribute available cash. It then lists powers that would turn the DST into a business entity — taxed as a partnership if it has two or more owners. Practitioners often call these restrictions the "seven deadly sins". The trustee may not:
- Dispose of the property and acquire new property.
- Renegotiate the lease or enter into leases with new tenants (the ruling allows an exception for the tenant’s bankruptcy or insolvency).
- Renegotiate or refinance the loan used to buy the property.
- Invest cash to profit from market fluctuations.
- Make more than minor non-structural changes to the property, unless the law requires them.
Example: matching value and debt in an exchange
An investor sells a rental property for $3,000,000 and pays off a $1,000,000 mortgage at closing, leaving $2,000,000 with the qualified intermediary. A common planning target for full deferral is to buy replacement property worth at least what was sold and to reinvest all of the cash. A DST interest bought with the $2,000,000, in a trust financed at 50% loan-to-value, carries a $4,000,000 share of the real estate and a $2,000,000 share of the trust’s debt.
| Line | Amount |
|---|---|
| Sale price of the property sold | $3,000,000 |
| Mortgage paid off at the sale | $1,000,000 |
| Cash held by the qualified intermediary | $2,000,000 |
| DST interest bought with that cash | $2,000,000 |
| Share of DST debt at 50% loan-to-value | $2,000,000 |
| Share of DST real estate acquired | $4,000,000 |
What to watch for
The same rules that make a DST work for a 1031 exchange also limit it:
- No new money: the trust cannot raise capital or refinance, so a property that needs a large repair or a new loan is a problem. Trust agreements usually provide a way out, such as converting to an LLC, and that can change the tax treatment.
- Illiquidity: there is generally no market for the interests. Investors are paid out when the property is sold, on the sponsor’s timeline.
- Costs: sponsor fees, selling commissions and the master tenant’s margin come out of the return. Read the PPM’s sources and uses.
- Concentration: a DST often holds one property with one master tenant.
- Deadlines: the 45- and 180-day exchange clocks run whether or not the offering is still open.
Primary sources
General information, not legal, tax or investment advice. Your operating agreement, offering documents, counsel and CPA govern your deal.