Let’s say you own several buildings in California worth $3 million, but there’s a catch - they have a very low cost basis. You’ve held onto them for years, watched their value grow, and now you’re tired of managing them. You want out. No more dealing with tenants, maintenance, or endless headaches.
But here’s the problem: selling means triggering a massive tax bill - somewhere between $800,000 and $1 million in capital gains taxes. That’s a painful cut out of your hard-earned wealth.
Like many high-net-worth investors, you start looking for a tax-efficient way to cash out, and the first thing that comes to mind is a 1031 exchange. But that would mean buying another property, managing tenants and staying in the game. And that’s exactly what you don’t want anymore.
That’s when you hear about the Delaware Statutory Trust (DST) - a way to defer taxes while getting completely out of property management.
It sounds like the perfect solution. But is it really? DSTs come with hidden traps that most investors don’t see until it’s too late. Before you commit, let’s break down the biggest risks and what better alternatives might be available.
What is a Delaware Statutory Trust?
But first, what exactly is a DST? A Delaware Statutory Trust is a legal entity that owns and manages real estate on behalf of multiple investors. Instead of owning a property directly, you buy a fractional share of a professionally managed trust that holds commercial properties like apartment complexes, office buildings, or retail centers.
The key selling point? DSTs qualify for a 1031 exchange. That means you can reinvest the proceeds from your property sale into a DST and defer capital gains taxes - just like you would with any other like-kind exchange.
But unlike traditional real estate ownership, you’re completely hands-off. The trust handles everything - tenant management, maintenance, and leasing. All you do is collect distributions while deferring taxes.
Sounds great, right? Well, before you get too comfortable, let’s talk about the costly mistakes investors make when investing in DSTs - because while they offer some clear benefits, there are common missteps that can leave you stuck with an investment that’s far from what you expected. Let’s go over what they are so you can avoid them.
Costly Mistake DST Investors Make
Mistake 1: Overlooking the Sponsor’s Track Record
One of the biggest mistakes investors make when choosing a DST is not properly vetting the sponsor. The sponsor is the company that selects, manages, and ultimately sells the property - meaning they have total control over your investment. And yet, many investors blindly trust the name on the paperwork without digging deeper.
Here’s why that’s a problem: Not all sponsors are created equal. Some have a solid track record of successfully managing DSTs, while others are more focused on collecting fees than ensuring investor returns. A bad sponsor can lead to poor property selection, mismanagement, or even financial instability that directly impacts your income and investment value.
Take ArciTerra Group, for example. This DST sponsor was taken over by the courts after being accused of mishandling $35 million of investor money. People who trusted them without doing proper due diligence found themselves caught in a financial nightmare.
Bottom line? You’re trusting the sponsor with your money - so make sure they deserve it. If you wouldn’t blindly hand over your investment portfolio to a stranger, don’t do it with a DST sponsor either.
Mistake 2: Failing to Evaluate How a DST is Financed
The next mistake investors make is overlooking how the DST is financed. Many focus on the tax benefits and passive income but fail to evaluate the debt structure - and that can make all the difference in returns.
Some DSTs take on high levels of debt to boost potential profits, but not all debt is created equal. A high loan-to-value ratio or reliance on floating interest rates can turn into a serious problem.
For example, if interest rates rise or the property needs to be refinanced under worse terms, your income distributions could shrink - or disappear altogether.
In fact, that’s exactly what happened to one of our clients before working with us.
She had invested in a Real Estate Limited Partnership, and when interest rates spiked after the pandemic, the Limited Partnership couldn’t service its debt. As a result, she recently lost her entire investment.
The same could easily happen with a DST. If a property is highly leveraged and interest rates climb, cash flow could dry up, refinancing could become impossible, and investors could be left with little to no return when the DST sells.
Debt can either enhance or destroy your returns. Before investing, make sure you understand exactly how the DST is financed - because once you're in, you have no control over what happens next.
Mistake 3: Overlooking the Risks of the Property and Market
A serious oversight some investors make is assuming all DST properties are solid investments. Just because a property is part of a DST doesn’t mean it’s automatically a good deal. Location, market conditions, and property fundamentals still matter.
Some investors don’t take the time to evaluate where the property is located or how it fits into the broader real estate market. A property might look great on paper, but if it’s in a declining area, has high vacancy rates, or relies on a struggling industry, it could be a ticking time bomb.
We’ve seen this firsthand with office buildings in major cities. Some investors poured money into DSTs holding office space just before work-from-home trends took off. Now, those properties are facing high vacancy rates, lower rents, and lower valuations. Investors who didn’t consider these risks are now stuck in a DST that may not perform as expected.
DSTs don’t remove market risk. If the location or asset class underperforms, so will your investment. Take the time to understand what you’re really investing in - not just the DST structure, but the property itself.
Mistake 4: Not Evaluating Tenant Risk Before Investing
Another critical mistake investors make is assuming that long-term leases guarantee stable income. While DSTs often promote their properties as having strong, creditworthy tenants, not all leases are as solid as they seem.
If a DST relies heavily on one or two major tenants, problems arise if those businesses start struggling. A long lease doesn’t help if the tenant can’t afford to pay rent. If they default or go bankrupt, your income distributions could plummet - or stop entirely.
This has happened with big-box retail tenants. Many investors believed a lease with a national retailer meant security, only for that company to file for bankruptcy and shut down locations. The DST still owned the building, but without a paying tenant, investors saw their income disappear.
DSTs often market their “stabilized income”, but that stability is only as strong as the tenants behind it. Before investing, take a close look at who’s paying the rent - because if they stop, so does your income.
Mistake 5: Being Trapped in a DST – Too Much Risk and No Control
A major many mistake investors make is putting too much money into a single DST and then realizing they have no control over it. Many assume that DSTs provide built-in diversification, but most are tied to a single property or a small portfolio, meaning your investment is entirely dependent on one asset, one market, or even one major tenant.
If that property underperforms - whether due to market downturns, tenant issues, or economic shifts - you have no safety net and no ability to step in and make changes. Unlike owning real estate directly, where you can decide when to sell, refinance, or make improvements, DST investors have zero control.
All major decisions - leasing terms, renovations, refinancing, and when to sell - are in the hands of the DST sponsor. We've seen cases where investors wanted to sell early to capture gains but were forced to stay in longer than expected, leading to weaker market conditions and lower returns. Others have watched rising expenses or declining rental income eat into their distributions, with no power to intervene.
Mistake 6: Liquidity Issues – Your Money Is Locked Up
One of the biggest drawbacks of DSTs is how difficult it is to access your money once you invest. Unlike publicly traded investments, which can be bought and sold easily, DSTs are highly illiquid by design - you can’t just cash out when you want to.
Many investors don’t fully realize this until it’s too late. If you suddenly need cash - whether for an emergency, a new investment opportunity, or a shift in your financial situation - you’re stuck.
Some investors assume they can find a buyer for their DST interest on the secondary market, but reselling DST shares is extremely difficult. Even if you find a buyer, you’ll likely have to sell at a steep discount, losing a significant portion of your investment.
Before committing, make sure you’re comfortable not having access to your money for several years.
Mistake 7: Uncertain Returns & Fees
Many investors assume that DST income distributions are guaranteed, but that’s not always the case. While sponsors often promote consistent passive income, those returns depend entirely on the property’s performance. If rental income drops due to vacancies, tenant defaults, or rising expenses, investor payouts can be reduced - or even suspended.
On top of that, fees can eat into your returns. These fees are often baked into the numbers, making projected returns look more attractive than they really are. Some investors don’t realize just how much these fees cut into their earnings until their actual returns come in lower than expected.
Always take the time to evaluate potential risks, fees, and market conditions before committing your money.
Better Alternatives to Delaware Statutory Trust
While DSTs might work for some investors in certain situations, they’re not the only option. Depending on your goals, risk tolerance, and liquidity needs, here are two alternative strategies that could be a better fit.
Real Estate Investment Trusts
If you want liquidity and diversification, a publicly traded Real Estate Investment Trust allows you to invest in real estate without tying up your capital for years. Unlike DSTs, REITs can be bought and sold anytime like stocks, making them a much more flexible option. They also provide exposure to a diversified real estate portfolio across different property types and markets.
However, REITs don’t qualify for 1031 exchange tax deferral, meaning any gains from selling a property would still be taxable. Additionally, REIT income is taxed as ordinary dividends, which may be higher than the capital gains tax rate. Despite these drawbacks, for those who prioritize liquidity and diversification, REITs can be a strong alternative to DSTs.
Installment Sales
If your main concern is capital gains taxes, but you don’t want to lock up your money in a DST or 1031 exchange, an installment sale, also known as seller financing, could be a great alternative. Instead of selling the property all at once and taking a big tax hit, you sell it over time, receiving payments from the buyer in installments.
By structuring the sale this way, capital gains taxes are spread out over multiple years, rather than being due all at once. This can significantly reduce your immediate tax liability, keep you in a lower tax bracket, and create a steady stream of income.
However, installment sales do carry risks - mainly, the buyer’s ability to keep making payments.
If the buyer defaults, you may have to go through legal action or foreclosure to regain control of the property. Because of this, it’s crucial to properly vet the buyer and structure the agreement carefully.
Real Estate Shelter Trust
If your goal is to fully diversify away from real estate and minimize capital gains taxes, a Real Estate Shelter Trust can be a highly compelling option. When structured properly, this trust qualifies as tax-exempt, providing significant tax advantages.
When appreciated real estate is contributed to the trust, the transfer occurs tax-free, allowing the trust to immediately sell the property without incurring capital gains taxes. Instead of losing a portion of the proceeds to taxes, the full amount can then be reinvested into a diversified portfolio, ensuring long-term growth and wealth preservation.
Another major advantage is that as long as the assets remain in the trust, no taxes are owed on income or capital gains generated by its investments. In addition, the contributor typically qualifies for a tax deduction of at least 10% of the contributed asset’s value.
For investors looking to transition out of real estate, reduce taxes, and diversify their investments, a Real Estate Shelter Trust can be a powerful tool.
Final Thoughts
DSTs may seem like an easy way to defer taxes and offload property management, but they come with serious trade-offs - from lack of control to liquidity risks and uncertain returns.
If you’re considering selling a highly appreciated property, don’t rush into a decision – one wrong move can cost you big. The tax bill on a sale can be huge, but with the right strategy, you may be able to reduce or even eliminate it. So before making a move, feel free to reach out to us, and we can figure out the best approach together to help you keep more of your wealth.
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