Delaware Statutory Trusts (often called “DST” but don’t confuse that with “deferred sales trust”) can be good solutions for certain very specific real estate tax planning purposes.
 
How do you know if a Delaware Statutory Trust is right for your client’s situation?
 
Consider Mark who owns $2 million of apartments in California. His basis is very low, and he’s tired of the hassle and wants to sell.
                                                                                               
But he doesn’t want to pay the $700,000 capital gains tax that would accompany the sale.
 
Is a Delaware Statutory Trust a good option?
 
Here are 10 top mistakes that Delaware Statutory Trust investors make, and why you should consider alternatives.
 

1. Failing to Conduct Due Diligence on the Sponsor

In a Delaware Statutory Trust investment, the sponsor is tremendously important, because once purchased, the property is locked in and cannot be sold or even refinanced without potentially creating negative tax consequences.

Therefore, due diligence on the sponsor is critical. The sponsor is responsible for acquiring, structuring, and managing the Delaware Statutory Trust property. If the sponsor lacks experience, has a poor track record, or engages in excessive fees and conflicts of interest, the investment could suffer.

Example: Arciterra
A stark example is the Arciterra Group, which has been placed in receivership and is alleged to have misappropriated approximately $35 million of investor funds. Arciterra sponsored a variety of real estate funds, including Arciterra Glendale Supercenter, Arciterra Mesa Office, and Arciterra National Portfolio. Each involved retail or office-focused real estate assets situated primarily in Arizona, with investors allocated beneficial interests in accordance with 1031 exchange rules. The receivership has its own website, here: https://www.arciterrareceivership.com/.

2. Ignoring the Financial and Debt Structure

Some Delaware Statutory Trusts use leverage, meaning they take on debt to finance property acquisitions. While this is quite standard in real estate investing, and properly used leverage can be a crucial component of returns, investors would be well advised to review and understand the loan terms, interest rates, debt maturities, and potential refinancing risks. If the Delaware Statutory Trust has an unfavorable loan structure—such as a high-interest rate, a short maturity period, or a balloon payment—there could be financial strain that impacts distributions or forces an untimely sale of the property.

3. Overlooking the Exit Strategy and Liquidity Risks

Delaware Statutory Trusts are by design illiquid investments. To obtain the tax deferral benefits, investors must hold their investment indefinitely. Furthermore, few Delaware Statutory Trusts have a market for interests, meaning that even if an investor no longer wants the deferral, there may be no ready buyer for the interest. Some investors enter DSTs assuming they can exit before the trust dissolves, only to realize that secondary market transactions, if available, often occur at a steep discount. Understanding the expected holding period and the likely exit strategy is crucial before investing.

4. Misunderstanding Cash Flow Projections

Investors sometimes rely too heavily on the projected distributions listed in the Private Placement Memorandum (PPM) without questioning the assumptions behind them. If cash flow projections are overly optimistic—such as assuming aggressive rent growth or underestimating expenses—actual returns may fall short of expectations. Evaluating historical financials, market rents, and expense assumptions is necessary to validate the projections.

5. Not Considering Market and Property-Specific Risks

While Delaware Statutory Trusts are often promoted as passive, stable investments, in most cases they are still subject to real estate market fluctuations. Investors may fail to take full account of a property’s location, tenant quality, and market trends. A Delaware Statutory Trusts that depends on a single tenant or a property in a declining market poses significant risks. Factors such as regional economic health, job growth, and industry trends should be assessed before committing capital.

6. Ignoring Concentration Risk

 Real estate may investors buy an interest in a Delaware Statutory Trust is to diversify out of their existing real estate holdings. However, most Delaware Statutory Trusts are not diversified, or are not very diversified. So, often, an investor exchanges out of a property that he or she owns, controls, and knows well, into a Delaware Statutory Trust that owns a property that the investor doesn’t know well, has no control over, and doesn’t even have any influence over. All the while, the investor still has the concentration risk.

7. Not Understanding Fees

It is not cheap to put together a Delaware Statutory Trust offering. There are many costs involved, and those costs all must ultimately come out of the investors’ capital. Delaware Statutory Trusts offerings typically come with a range of upfront and ongoing fees, including acquisition fees, management fees, and disposition fees. High upfront costs can reduce the percentage of the capital raised that actually goes into the property, making it more difficult for investors to achieve expected returns. A thorough review of the fee structure will help an investor evaluate the level of costs in comparison to alternatives.

8. Failing to Assess Tenant and Lease Strength

Many Delaware Statutory Trust investments rely on a single tenant or a few major tenants for rental income. If the primary tenant vacates or defaults, the Delaware Statutory Trust may struggle to maintain cash flow. Investors may be at a disadvantage in reviewing lease agreements, tenant creditworthiness, lease duration, and renewal options. Properties with long-term, investment-grade tenants provide more stability than those with shorter leases or weaker tenants. However, note that the more stable and reliable the tenant, everything else equal, the lower the yield and investor return are likely to be.

9. Underestimating Interest Rate and Refinancing Risks

Delaware Statutory Trusts investments with variable-rate debt or short-term financing can be heavily impacted by rising interest rates. If rates increase and the Delaware Statutory Trusts needs to refinance, the new loan terms could result in higher debt service costs and reduced investor distributions. Fixed-rate financing with a long-term maturity generally provides more stability in uncertain economic environments. In commercial real estate markets, however, truly long-term financing, such as is available in the residential mortgage market, is rarely available. For levered investments in real estate, the refinancing risk may be unavoidable.

10. Not Fully Considering Alternatives

Investors may prematurely decide that a Delaware Statutory Trust is the solution without fully considering the alternatives. Most Delaware Statutory Trust investments are made via a 1031 exchange. The 1031 exchange allows a real estate investor to defer recognition of capital gains on the sale of the property.

When a real estate investor is selling a property at a gain, there are other tax advantaged methods of selling that should be considered along with a Delaware Statutory Trust. One of these is the Real Estate Shelter Trust. To learn more, request a free copy of Sterling’s Advisor Guide to Appreciated Real Estate.

Conclusion

Because of the limitations of Delaware Statutory Trusts, particularly their inflexibility and relatively high costs, the vast majority of Delaware Statutory Trust investors enter into the investment via a 1031 exchange under which they defer gain on a prior real estate investment. In some of these cases, the Delaware Statutory Trust is the best solution. In other cases, the investor would have been well advised to conduct more thorough due diligence, including looking at alternatives to a Delaware Statutory Trust, before making the commitment.