A Tale of Two DSTs: Beware of Confusing 1031 DSTs with 453 DSTs
Real estate investors may be familiar with the acronym DST, which in the context of Internal Revenue Code Section 1031 like-kind exchanges, refers to a Delaware Statutory Trust. A 1031 DST is a vehicle by which a seller of real estate can defer gain on the sale of business or investment real estate by exchanging it for new real estate along with other investors. While a seller can certainly buy a replacement property, the Internal Revenue Code does not permit replacement property to be acquired with others through a partnership (or multi-member limited liability company). For a seller who wishes to exchange into a larger quality replacement property but does not have sufficient funds to buy the entire property, the 1031 DST is a way of allowing for joint ownership that is not a tax partnership and, therefore, is allowable under Code Section 1031.
Every few years, another form of DST makes the rounds, including as an alternative to Code Section 1031. This is what is commonly referred to as a “Deferred Sales Trust,” where the seller sells real estate (or other business assets) to an intermediary in exchange for an installment note. The deferral technique does not rely on Code Section 1031, but on the Internal Revenue Code’s installment sales rules (Section 453) to defer gain over the period in which principal payments are made on the installment note. Immediately following the sale of the real estate to the 453 DST, the 453 DST sells the real estate to the ultimate buyer for cash. The 453 DST invests the cash in a way that produces returns that allow the 453 DST to service the installment note to the original seller. There are many nuances to the installment sale rules and structuring 453 DSTs involves considerable complexity.
Apart from the complexity there is meaningful risk, both tax and commercial. While the 453 DST technique has been around for a while, it has been promoted over the years by legitimate sponsors and sponsors who can best be described as sketchy. One is entrusting substantial funds to a trust that is often administered by a non-institutional party, which presents considerable risk even when the funds are invested with a recognized financial institution (such as an annuity issuer). Much of the structuring of 453 DSTs occurs in something of a black box.
Most tax practitioners have looked at 453 DSTs with a high degree of skepticism. LP’s view of most 453 DSTs is that they are ineffective to defer gain on sale. The reasons are myriad. Despite advice to the contrary, sellers have sometimes been dismissive of the tax risk, relying on the 453 DST sponsor’s assurances and references to tax opinions that are often never seen.
In August 2023, the IRS added “monetized installment sales” (similar to most 453 DSTs) to its “Dirty Dozen” list of common tax scams and schemes. The tax and commercial risks should put the nail in the coffin of most 453 DST arrangements, but sellers often make grievous errors of judgment when 453 DST sponsors refer loosely to DSTs and sellers conflate those with legitimate 1031 DSTs.
Attorneys in LP’s Real Estate and Tax Planning Groups can help you assess DSTs and other tax planning strategies. Please don’t hesitate to reach out.