How DST Sponsors Report Taxes at Year-End
How DST Sponsors Report Taxes at Year-End
Commercial real estate is a highly tax advantaged industry, and this is true whether someone invests in real estate directly or passively through a syndication, fund, or Delaware Statutory Trust (DST). In all cases, investors can write off significant expenses, like depreciation, that can potentially offset the taxes they would otherwise pay on income earned from those assets.
In this article, we look at what DST investors need to know ahead of filing their tax returns each year.
What is a Delaware Statutory Trust?
A Delaware Statutory Trust, or DST, is an investment vehicle in which the trust holds title to one or more income-generating properties. The trust is overseen by a sponsor who manages the real estate on investors’ behalf. Investors own a pro-rata share of the assets held by the DST. In other words, a DST is a way for investors to fractionally invest in commercial property.
There are many potential benefits associated with investing in a DST. Many people will sell individually-owned property and then roll the proceeds of that sale into a DST using a 1031 exchange, a process that allows them to defer paying capital gains tax. DSTs also allow investors to move from actively managing their real estate investments to being completely passive, since DST investments are managed by the DST sponsor – a third-party that is generally highly-experienced and adept at overseeing and acquiring significant real estate deals.
How is DST Income Reported?
The IRS classifies ownership in a DST as direct ownership of real estate for tax purposes. Therefore, rather than receiving a K-1 or traditional 1099, DST shareholders will receive a “substitute 1099” form from the DST sponsor. This substitute 1099 includes some version of the DST’s operating statement that outlines the investor’s pro-rata share of income and expenses associated with the DST’s assets.
The DST sponsor will generally send one substitute 1099 statement for each property owned by the DST that outlines the income and expenses for that specific asset.
If there is any income earned from the DST, the investor must report their pro rata share of that income on their IRS Schedule E when they go to file their taxes – just like they would for real estate owned individually or directly. This income will be treated and taxed as ordinary income.
Here is a quick primer video from DST sponsor, Inland, that shows how DST income is reported by DST sponsors using these forms: http://go.inland-investments.com/Substitute-1099-1098
Can DST Investors Take Deductions or Depreciation?
Because DST investors indirectly own a fractional share of the real estate held by the DST, these investors can write off their pro rata share of expenses and depreciation – key deductions that can help offset the tax burden associated with the income they’ve earned on their DST investment(s) that year. Investors can therefore seek to maximize their returns by reducing the amount of money they owe to the IRS. Depending on the value of the deductions, there may be excess savings that can be applied to the investors’ other sources of income as well (note: passive losses can only be used to offset passive income, not “active” income such as that earned through a W-2). Investors can also claim their pro rata share of depreciation associated with the DST assets, which can potentially be significant if the DST sponsor does a cost segregation study and accelerates depreciation in the first few years of the hold period.
We recommend speaking with your tax professional like a CPA or tax lawyer to walk through all year-end statements to determine which deductions might be applicable.
Reporting DST Income in Multiple States
Investors must file a tax return in every state in which they have real estate holdings; the same is true for DST investments. If the DST property is different from the state in which the investor lives, they must report the income as required by that state. Some states, like Texas, Florida, Nevada and Washington, have no state income tax. Other states have what’s known as “de minimis” filing standards, which means that income tax only needs to be reported if it exceeds a certain threshold. If the DST has real estate assets in multiple states, investors must file tax returns in each of those respective states as well.
Top Mistakes People Make When Reporting DST Income
Despite an investor’s best intentions, it is easy to make mistakes when reporting their DST income. This is because the reporting documents that a DST sponsor issues can vary. Some will issue reports that are 500+ pages long. Others will provide simple, 1-2 page forms that include the bare minimum in terms of information. Finding the information needed to accurately report DST income is essential and often requires the support of a tax professional experienced with DSTs.
Here are some of the most common mistakes people sometimes make when reporting DST income on their tax returns:
- Amortizing repairs instead of taking the deduction in the current year.
Repairs, unlike major capital improvements, can be deducted in the year in which the repair occurred. Most DST sponsors will report expenses as property improvements. It is up to the DST investor (i.e., their tax preparer) to classify those improvements as either repairs or capital expenses. The investor should also be looking for whether those costs were paid by the DST operating account or out of the reserves, which impacts if and to what extent they can be depreciated.
- Not amortizing loan fees.
The loan fees should be outlined in the private placement memorandum, or PPM, and can be deducted to offset an investor’s earned income. This is why it is essential that you provide your tax advisor with a copy of the PPM if you have not done so already.
- Not taking all applicable deductions.
Many DST investors will hire a tax preparer to assist with their income tax reporting, but unless those tax advisors specialize in real estate, including DSTs, they might only read the first page of the substitute 1099 that summarizes income and expenses. They might overlook potential deductions associated with repairs, tenant improvements, lease commissions, and the like.
- Ignoring the tax treatment of DST reserves.
DSTs will generally have an escrow account holding some amount of reserves to be used for unforeseen expenses. This is a way to ensure DSTs remain solvent, since they cannot make capital calls from their investors. However, reserves are not considered part of the property cost and should therefore not be used by investors when calculating the cost of replacement property when doing a 1031 exchange. Instead, investors who have done a 1031 exchange into a DST should reduce the purchase price (of their interest in the DST) by the amount of the reserves.
- Not filing a tax return in each state in which the DST holds assets.
As a reminder, if a DST owns property in multiple states, a tax return must be filed in each state that requires investors to pay income tax. Not filing those returns could subject you to interest and penalties. Once a DST sponsor files their taxes in that state, it begins the clock on the statute of limitations for which states can go back and audit or request further payment from investors.
- Not claiming credit for taxes paid to other states.
For those who report DST income in multiple states, they may be eligible for a credit and a refund of that tax on the tax return for the state in which they personally reside. For example, if you live in California but have invested in a DST that owns property in North Carolina, you will file a tax return in North Carolina but then should get a tax credit on your income tax return in California.
When Must DST Investors File their Taxes?
When a DST investor files their taxes depends on what sort of entity they’ve used to invest in the DST. Those who have invested in a DST individually (e.g., in their own name) or via a pass-through entity like an estate, trust or C-Corp, have until April 15 to file their taxes each year. Most people who invest in a DST use one of these investment vehicles. However, on occasion, someone may invest in a DST through an S-Corp or partnership, in which case, they are required to file their taxes earlier, by March 15, each year.
Of course, this assumes “normal” tax deadlines. Tax filing deadlines are sometimes extended due to extraordinary circumstances, like the covid pandemic in 2020. Individuals may also seek an extension if they need more time to file. In any event, it is important to monitor these deadlines closely to remain in compliance with IRS obligations. Investors should speak with their tax professionals for guidance.
We always recommend hiring a tax professional like a tax attorney or CPA to assist with your tax preparation and filing. When interviewing potential tax advisors, be sure to inquire about the professional’s experience with DSTs specifically. Working with someone who understands the mechanics of DST income and expense reporting will help to ensure you are maximizing the value of potential deductions while remaining compliant with all IRS guidelines. Protect yourself by working with a pro.
Not an offer to buy, nor a solicitation to sell securities. Information herein is provided for information purposes only and should not be relied upon to make an investment decision. All investing involves risk of loss of some, or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing. Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.
1031 Risk Disclosure:
- There is no guarantee that any strategy will be successful or achieve investment objectives;
- Potential for property value loss – All real estate investments have the potential to lose value during the life of the investments;
- Change of tax status – The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;
- Potential for foreclosure – All financed real estate investments have potential for foreclosure;
- Illiquidity – Because 1031 exchanges are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.
- Reduction or Elimination of Monthly Cash Flow Distributions – Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;
- Impact of fees/expenses – Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits