Delaware Statutory Trusts (DSTs) have gained significant popularity among real estate investors for their flexibility, asset protection, and tax deferral advantages. However, understanding the intricate details of DSTs, particularly grantor trust letters and tax reporting requirements, is crucial for beneficial interest owners to maximize the tax benefits and mitigate risks associated with these investment vehicles.

What is a Delaware Statutory Trust (DST)?

The Internal Revenue Code Section 1031 provides for the tax deferral of gains if proceeds from investment property sales are reinvested in like-kind assets. 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 Sec. 1031. Effectively, a DST is a grantor trust that is disregarded for tax purposes, and thereby investors acquiring a fractional interest in a DST are acquiring a qualified replacement real estate asset for Sec. 1031 despite owning less than 100% of such DST’s total beneficial interest. Beneficial owners are treated as having a direct interest in an allocable proportionate share of all of the DST’s real estate and other assets, liabilities, income, deductions, credits, and distributions.

Grantor Trust Letters: Understanding the Basics

A DST employed as a tax deferral vehicle must be an investment trust and not a partnership nor a corporation. Partnerships and corporations annually issue to their partners and investors Schedule K-1s or Form 1099s that present to each investor their respective distributions, income, deductions, and other tax reporting information. DSTs, instead, 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, unlike Form 1099 and Schedule K-1. While the format may not be consistent, the contents of the grantor trust letters will resemble Schedule K-1 with respect to distributions and allocations of revenue and expenses.

DST Tax Reporting Requirements for Beneficial Interest Owners

One of the primary considerations for DST investors and their tax accountants is understanding the tax implications associated with their investment.

Grantor trust letter reporting is essential for DST investors as it provides documentation of income from the trust throughout the tax year. Beneficial interest owners should ensure that they receive the grantor trust letter from the trust sponsor or trustee or have it uploaded to DST investor portals for inclusion in their tax return Form 1040 filings. The grantor trust letter will include the beneficial owner’s proportionate share of the DST’s rental income, deductions, and credits and the DST’s distributions to each beneficial owner during the reporting period.

Rental income is recognized when earned and also if received in advance for tax purposes. At times, a DST’s rental income greatly exceeds the distributions because of receiving rents from tenants in advance and is reported in the earlier year of receipt rather than when earned. “Phantom income” may also arise if the DST property is cash flowing from operations but cash is insufficient to make distributions. For instance, a DST mortgage lender’s loan terms may provide for cash “traps” upon the occurrence of certain events and while the property’s operations may yield sufficient cash to operate the property, the cash trap event trigger may result in the suspension of distributions until such a trigger event has been cured. In such an instance, the grantor trust letter may report rental income despite the suspension of distributions.

An investor will not find depreciation on the grantor trust letter because depreciation calculations are investor-dependent. Each investor will have their individual carryover basis from their relinquished real estate investment if buying into the DST pursuant to a like-kind exchange. 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). As such, unlike a partnership’s Schedule K-1, an investor’s basis information is typically not found in the grantor trust letter.

Information from the DST sponsor will also be required to allocate an investor’s acquisition price of the beneficial ownership interest in the DST between non-depreciable land and depreciable building.

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.

Further, a DST may dispose of one or more of its properties but less than the entire portfolio. Such sale information will be provided in the grantor trust letters, but proceeds from such sale must be distributed to investors and the DST cannot reinvest the sale proceeds because the DST is an “investment trust”. Investors should be notified of such partial portfolio sale prior to the sale in order to protect the beneficial interest owner’s ability to utilize tax deferral strategies on such partial portfolio sale.

Conclusion

While DST syndications are 20 years old and the volume of DST syndications has swelled, 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. By prioritizing compliance and staying informed about tax developments, investors can capitalize on the benefits of DSTs while minimizing potential risks associated with their investments.