Delaware Statutory Trusts (DSTs) have become increasingly popular with investors seeking to defer capital gains taxes through 1031 exchanges. They are marketed as offering passive income, access to institutional-quality properties, and professional management. While these benefits can be appealing, they often mask serious risks. DSTs are complex, illiquid, and can expose investors to losses they never anticipated.
If you’ve been pressured into making an investment such as a DST that you didn’t fully understand or you felt didn’t align with your investment portfolio, you’re not alone—the securities fraud lawyers at Meyer Wilson Werning can help. Reach out today to discuss your next steps with us.
Understanding How DSTs Work
When you invest in a DST in a 1031 exchange, you do not directly own real estate. Instead, you purchase a beneficial interest in a trust that holds the property. The sponsor—often a large real estate firm—makes all management and operational decisions. This arrangement allows DSTs to qualify for tax deferral under IRS Revenue Ruling 2004-86, but it also means investors surrender control. That tradeoff can have serious consequences if the sponsor makes poor decisions or if market conditions change.
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The Top 8 Risks of DST Investments
DSTs carry multiple layers of risk that aren’t always clear in the marketing materials. Below are the eight most significant risks, with examples for how they can affect investors.
1. Illiquidity and Lock-Up Periods
DSTs are designed as long-term, buy-and-hold investments, usually with a 7–10 year horizon. There is no active secondary market for DST interests, which means you cannot simply sell your stake the way you would with a stock or public REIT.
For example, imagine you invest $300,000 into a DST and then need access to that money for a medical emergency two years later. Unlike a traditional real estate holding that you could sell or borrow against, your DST funds are essentially locked. This lack of flexibility is particularly damaging for retirees or investors who need reliable liquidity.
2. High Fees and Commissions
DSTs often come with multiple layers of costs: acquisition fees, asset management fees, disposition fees, and high upfront commissions (often 7–10%). These costs immediately eat into returns.
For example, consider a DST projecting a 6% annual return. After deducting 2% in annual fees, the return falls to 4%. Over a 10-year investment, that difference compounds into tens of thousands of dollars lost. Advisors selling these products may also have a conflict of interest, as the high commissions incentivize recommendations even when the investment is unsuitable.
3. Limited Investor Control
With DSTs, investors are passengers, not drivers. You cannot renegotiate leases, refinance loans, or decide when to sell the property. Those decisions are solely in the sponsor’s hands.
For instance, if the anchor tenant in a DST-owned shopping center vacates, investors cannot step in to negotiate a new lease or pursue a new tenant. If the sponsor fails to act quickly or effectively, property income can plummet, and investors bear the losses. For individuals used to managing their own properties, this lack of control can be a frustrating and costly adjustment.
4. Market Volatility and Economic Downturns
DSTs are tied to real estate markets, which are cyclical and vulnerable to downturns. Property values, rental income, and occupancy rates can all be affected by broader economic shifts.
The 2008 financial crisis serves as a clear example: property values across the country collapsed, and DST investors were not immune. Many saw losses of 30% or more. Even outside of a crisis, factors like rising interest rates or regional economic weakness can significantly reduce the performance of a DST property.
5. IRS and Regulatory Risks
DSTs qualify for tax deferral under IRS Revenue Ruling 2004-86. However, this benefit is not ironclad. The IRS could disallow certain DST structures or issue unfavorable guidance.
Imagine an investor deferring $200,000 in capital gains taxes through a DST. If the IRS later rules that the structure does not qualify for 1031 treatment, that investor could suddenly face a massive tax bill, plus interest and penalties. Given the size of many DST investments, such a change could be financially devastating.
6. The “Seven Deadly Sins” Restrictions
To preserve tax advantages, DSTs must comply with seven rigid rules known as the “seven deadly sins.” These rules prevent DSTs from raising new capital, renegotiating loans, or reinvesting proceeds, among other restrictions.
In practice, this rigidity makes DSTs inflexible during changing market conditions. For example, if a DST-owned office building loses its primary tenant, the trust may be prohibited from making necessary lease changes. This inability to adapt can leave properties underperforming and investors exposed to prolonged income loss.
7. Concentration Risk
Unlike diversified REITs, many DSTs focus on a single property or small group of properties. This concentration means performance is tied to just one asset or tenant base.
If the DST invests in an apartment building and rental demand in that area falls, or if a key tenant in a commercial property defaults, investors could suffer significant losses. Lack of diversification magnifies the impact of any single issue.
8. Sponsor and Management Risk
Finally, investors in DSTs are highly dependent on the sponsor’s expertise and integrity. Poor management decisions, conflicts of interest, or lack of transparency can directly reduce returns.
For example, if a sponsor delays selling the property to collect additional fees or makes questionable tenant selections, investors have no recourse. This reliance on third-party judgment makes the sponsor one of the biggest risks in any DST investment.
Tax Benefits and Their Fragility
The promise of deferring capital gains taxes is what draws many investors to DSTs. But those benefits only exist as long as the IRS continues to recognize the structure. The combination of rigid compliance rules and potential for changing tax policy makes these benefits more fragile than many investors realize.
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How Meyer Wilson Werning Helps DST Investors
DSTs are often marketed as low-risk ways to diversify and defer taxes, but for many investors they have produced significant losses instead. At Meyer Wilson Werning, we represent investors who were misled about DST risks or who were sold unsuitable DST investments by financial advisors. If you’ve lost money in a DST, contact us today so our team can evaluate whether your advisor or brokerage may be liable and help you pursue recovery.
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Frequently Asked Questions
What is a Delaware Statutory Trust (DST) in real estate investing?
A DST is a legal structure that allows investors to buy a beneficial interest in a trust that owns real estate, often used for 1031 exchanges. While it provides tax deferral, it also means investors give up control to the sponsor.
Why are DST investments considered risky for investors?
DSTs are illiquid, highly fee-driven, and subject to market volatility. Investors often face lock-up periods of 7–10 years with no ability to sell early.
How do fees and commissions impact DST returns?
High upfront commissions (often 7–10%) and annual management fees reduce potential returns significantly. These costs create conflicts of interest for brokers recommending them.
Can investors lose money in a Delaware Statutory Trust during downturns?
Yes. Because DSTs are tied to real estate markets, economic downturns, rising interest rates, or tenant defaults can cause serious losses.
What legal options do investors have if a DST investment was misrepresented?
If brokers failed to disclose risks or recommended DSTs to unsuitable clients, investors may have claims for recovery. Arbitration is often the primary path to pursue compensation.
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