Beyond owning the bragging rights as the first state the ratify the constitution and being the home of Joe Biden, Delaware also happens to be one of the most tax friendly of America’s 50 states. Correspondingly, there are numerous incentives that attract business and money to the state. One of the most well-known is the Delaware Statutory Trust.
But what is the Delaware Statutory Trust (DST)? A DST is an agreement between investors who invest in property, but manage the rental of said property through a trustee. Effectively, it is an easy way to make passive income through rental properties while being absolved of the task of managing the property yourself.
If your interest has been piqued, then it would be a good idea to talk to a group like Peregrine Private Capital. If you’re still after a bit more information, then we break down DSTs in more detail below.
Business trusts are nothing new and have been in use since 16th century England. These trusts were traditionally used by super-rich entities like life insurance companies and pension funds to easily pass on assets between generations or family members. They offered lower taxes and more security. More recently, they have grown into mini-businesses between investors who share in the profits acquired from rent.
In 1947, statutory trusts began to be recognized in common law in Delaware, but it wasn’t until 1988 that DSTs were recognized as their own legal entity. This gave DSTs freedom from the corporate law template, allowing investors to take advantage of similar protections to that of a limited liability company, effectively allowing them to act as such. Since the turn of the millennium, DSTs have become an ideal way to take advantage of tax deferrals on capital gain.
How Can You Get a DST?
The process of getting a DST is relatively simple. All parties must produce a private trust agreement which must be signed and agreed on to ensure all interests are protected. Interestingly, and unlike most business paperwork, the agreement does not need to be shown to state officials before being made official.
Once this is finished, a Certificate of Trust must be received from the Delaware Division of Corporations for all parties to sign. Along with the submission of all mentioned paperwork, a one-time processing fee of $500 must be paid.
If the trust is to become a registered investment company, then it must have an official place of business in Delaware. If not, then the only requirements are that at least one investor either resides in Delaware or maintains a business within the state.
How Does a DST Work?
The first thing to consider in this equation is a 1031 exchange. This tool permits a home owner to defer capital gains taxes when a property is sold. This transpires when the seller reinvests those funds in another investment.
In a way, a DST is a subsidiary of a 1031 exchange. It takes the principles of a 1031 exchange but allows for numerous parties to become involved in a single property. These investors will pool their money together and hold fractional amounts of the asset depending on their financial input.
There are three groups of people to consider when setting up a DST: the sponsor, the trustee(s), and the trustor. In general, it is customary that a sponsor will establish the DST. What will then happen is the sponsor will name the trustees. The trustees are the ones who look after the business aspect of the asset. This leaves them with the responsibility of hiring a property manager (if they so wish) and making decisions on the upkeep of the property. Though these trustees have a legal responsibility to the trustors, otherwise known as the investors or the fractional owners.
The lifespan of a DST will, unsurprisingly, fluctuate on a case-by-case basis, but on average they tend to last for around 10 years. If making property investments is something you’re interested in, then a DST can be a safe introduction for those with ties to Delaware.
What are the Pros and Cons of a DST?
There are pros and cons to everything and a DST is no exception. One of the most notable advantages is that, from an individual perspective, it permits your partial investment to be eligible for like-kind for exchange purposes. This unlocks investment opportunities not previously available to you. With the DST established, the investor can now move large scale funds (from the sale of a home, for example) into new property investment areas. This includes office spaces and industrial properties which can be purchased and managed through a fractional ownership DST arrangement.
Another advantage is the distance an investor has from the asset. Individual investors tend to hire property managers to take care of the day-to-day operations. Though with DSTs, that property manager will typically be an institutional organization. This makes for a stress-free investment for the investors who can enjoy passive income without the headaches one can face when very close to the property.
There are of course some disadvantages to DSTs. This hands-off approach to property investing may not sit well with some. In a DST, it is the institutional managers or the trustees who make all management decisions on the property. If withdrawing any kind of control over the running of the asset or having someone else make decisions with your capital is something you can’t bear the thought of, then DSTs may not be ideal for you.
The lack of liquidity in a shared property purchase can also be a point of tension in a DST. In theory, an investor is able to sell their share of a DST at will. However, in practice, the resale market for an active DST is practically non-existent. If you are adamant on selling off your portion of a DST, it is likely that you will suffer a significant loss for having abandoned the agreement early. As DSTs are typically formed within an established circle of trust, other investors may dislike the idea of bringing a new and unknown investor into that circle. This can potentially damage your trustworthiness, your reputation, and relation with said investors.
Statutory Trusts vs. Common Trusts
Trusts, in their various forms, are prevalent throughout the country, though only Delaware gets to take advantage of DSTs, a style of trust that is perceived to be more generous and less outdated than common trusts used outside of Delaware.
When it comes to common trusts, the generated income is susceptible to income tax. Whereas DSTs are exempt from paying income tax. Additionally, DSTs are also exempt from paying franchise tax. So, aside from the $500 processing fee, there is nothing else to pay.
If an investor of a common trust becomes bankrupt, accrues major debts, or comes into financial hardship, then their assets can become liable for creditor claims. DST investors, on the other hand, waive personal liability on their asset, effectively protecting their and their fellow investors’ share of the trust from external financial matters.
DSTs are also incredibly flexible. There are no specific requirements as to how the contract should be worded or vocabulary used. This gives all parties a great deal of autonomy in deciding who gets what rights and responsibilities in the trust. DSTs don’t have to be written in English, and there is no requirement as to where or how the contract is stored.
Why are DSTs Only Available in Delaware?
The state of Delaware is colloquially referred to as the Cayman Islands of America due to its lax tax laws and business-friendly outlook. Most of America’s biggest transnational companies hold offices in Delaware. Many maintain little more than an office in the state. This permits them to reroute their earnings through Delaware to avoid incurring a regular sized tax bill that would have to be paid elsewhere.
As the first constitutionally ratified state, Delaware has been conducting business since 1792, a major head start over other states. In the early decades of the 20th century, Delaware was rewriting its tax laws to attract businesses, both large and small, to the state from its neighbours of New York, New Jersey, and those further away.
So friendly are the tax laws that in 2011, over 133,000 businesses either moved to or were established in Delaware. Corporate entities even outnumber people by a staggering 1.5 million to just 973,000.
The legislatively dynamic state of Delaware harbours some of America’s greatest tax incentives. The relatively simple set-up of a DST, its one-off fee, and low risk to reward make this quite an attractive option for both novice and experienced investors. While there are pros and cons to DSTs, they are far superior to their counterpart, the common trust, mostly utilized throughout the rest of the country.
Michael Perry has been interested in business ever since he was young and spent most of his life learning about this industry. Today, Michael shares his knowledge on business by publishing highly informative articles and videos on his blog.