How Property Reserves Work in a Delaware Statutory Trust (DST)
DST investors may pay taxes on income that is being held back as reserve funds for future improvements to the property. It's no cause for alarm, as taxes today mean tax benefits tomorrow.
Editor's note: This is the second article in a two-part series on investing via Delaware statutory trusts (DSTs) investing. The first is Why a "Fee-Based" DST Investing Sales Pitch is a Red Flag for Investors.
Delaware statutory trust (DST) investors sometimes ask, "Why am I paying taxes on more income than I actually received in cash?"
At first glance, it may seem confusing. However, this is not unique to DST investing — it is the same concept that has applied to direct real estate ownership for decades.
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This is how we explain it at Kay Properties and Investments, which has been helping thousands of DST investors for nearly 20 years, and where I'm the CEO.
A simple example
For decades — indeed, for generations — real estate owners and landlords have followed the same basic financial principle: Not every dollar of rental income should be distributed immediately. A prudent owner plans ahead by setting aside reserves for future expenses that potentially protect and preserve the property's value.
Imagine you personally own a commercial building that generates $200,000 in annual rental income. During the year, you discover the roof has reached the end of its useful life and will need to be replaced in the near future. Rather than distributing every dollar of rental income to yourself, you wisely retain a portion of the cash flow each month to build a reserve fund for the future roof replacement.
At year-end, you may have only withdrawn $150,000 in cash, with the remaining $50,000 held in the property's bank account as reserves.
Even though you didn't receive that $50,000 personally, it is still income generated by your property. Under IRS tax rules, you generally report the property's taxable income — not simply the cash you chose to distribute to yourself.
At first, this may result in you paying tax on income that remained in the property's reserve account.
However, when those reserve dollars are ultimately used to replace the roof (or any other type of repair or investment in the property, such as resurfacing the parking lot, renovating space for a new tenant or completing other improvements), those expenditures become investments back into the property.
As those costs are recognized for tax purposes over time — major improvements are generally depreciated over their recovery periods rather than deducted all at once — they generally provide write-offs, expenses and future tax benefits to the property's owners, making the earlier timing difference largely a matter of when the expense and tax benefit is realized rather than whether it is realized.
This has been standard practice among real estate owners for decades and is simply part of responsible property ownership and long-term asset management.
How rental income is reported in a DST
Just as with direct real estate ownership, a DST property receives rental income from its tenants throughout the year.
Business tenants that pay rent in the course of their trade or business generally report the rent paid to the property on IRS Form 1099. The DST asset manager receives these forms on behalf of the investors and typically prepares a Nominee 1099 allocating each investor's proportional share of the property's gross rental income.
The Nominee 1099 is primarily an informational reporting document that helps reconcile the rental income reported to the IRS. It is not the document used to calculate an investor's taxable income. Instead, it serves as a record-keeping tool that ties together the gross rents reported by tenants with each investor's ownership interest in the DST.
In addition, DST investors receive a calendar-year balance sheet and income statement for the property. These financial statements reflect the full year of property operations and are prepared by the DST sponsor.
This financial information breaks down the entire DST property's financial information as well as further details of each individual investor's percentage ownership of the DST and their corresponding pro rata numbers. Typical DST financial information at year-end will include the property's gross rental income, operating expenses, net income and balance sheet.
The net income based on your pro rata percentage interest in the DST is an important starting point, but your CPA or tax preparer will adjust it — most notably for depreciation — when preparing your tax return, generally relying on the tax reporting package (often a grantor letter) provided by the sponsor rather than the operating statement alone. (Read on for why cash-basis net income and taxable income are not the same figure.)
Why cash distributions and taxable income may be different
DST investors may have questions if the amount of cash distributions they receive during the year is less than the taxable income reported by the DST property.
This difference is completely normal in commercial real estate whether the investor owns the property outright or a percentage of a DST.
One of the primary reasons is that prudent property management often requires retaining cash to build reserves for future property needs rather than distributing every available dollar to investors.
Those reserves may be accumulated for:
- Tenant improvements for lease renewals or new tenants
- Leasing commissions to secure a new tenant
- Roof replacements
- Parking lot resurfacing
- HVAC replacements
- Landscaping and exterior improvements
- Other major capital expenditures that preserve and improve the property
Although these reserve dollars may temporarily reduce current cash distributions, they remain assets of the property and continue to belong to the DST investors collectively based on their proportional ownership interests.
The reserves are not owned by the DST sponsor or asset manager — they are investor-owned funds being held at the property level for future capital needs. If reserve funds ultimately are not needed for their intended purpose, those funds remain property assets and will be distributed back to investors on a pro rata basis upon the sale or disposition of the property, consistent with the governing DST documents.
Two other reasons taxable income can differ from cash distributions received
Depreciation. One of the most significant tax features of real estate is depreciation. Each year the tax law allows the property's owners to deduct a portion of the building's cost, even though no cash is actually spent.
In the early years of a DST hold, depreciation often shelters a substantial portion of the property's net income — which is why many investors initially report taxable income that is lower than the cash they receive.
As those depreciation deductions decline over the hold period, taxable income tends to rise relative to cash flow.
Mortgage principal. In a leveraged DST, repaying mortgage principal uses the property's cash but is not tax-deductible. As depreciation deductions decline and a growing share of each mortgage payment is applied to principal, an investor may report taxable income that exceeds the cash actually distributed.
This effect — sometimes called "phantom income" — is a normal feature of leveraged real estate, whether owned directly or through a DST, and works alongside the reserve timing difference described in the main article.
The real estate ownership timing difference: Taxes today, tax benefits tomorrow
One point that is often overlooked is that reserve building generally creates a timing difference, not necessarily a permanent tax cost.
During the period reserves are being accumulated, an investor may report more taxable income than the amount of cash actually distributed because some of the property's cash flow has been retained for future capital needs.
However, when those reserve dollars are eventually used — to replace a roof, resurface a parking lot, install HVAC systems and so on — the property incurs those expenditures on behalf of its owners. Because each DST investor owns a beneficial interest in the property, each investor will receive their proportional share of the expenses and write offs associated with those capital expenditures.
As those reserve dollars are invested back into the property, the related expenses and write-offs are passed through to investors based on their ownership interests, helping offset taxable income over time. Because most of these items are capital in nature, the related deductions are generally realized gradually through depreciation and amortization rather than entirely in the year the reserves are spent.
In other words, while a DST investor may have paid tax earlier because reserves were accumulated instead of distributed (the same way as when they directly owned real estate and built reserves), those future expenses will help offset taxable income in later years.
What initially appears to be paying tax on "income you didn't receive" is often simply a matter of tax timing rather than an additional permanent tax burden. This is the case whether you own an interest in a DST or own a property outright.
Example timeline: How a reserve timing difference works
Imagine you own a 1% interest in a DST.
Year 1
- Rental income allocated to you: $100,000
- Cash distributed to you: $95,000
- Reserved by the property for future capital improvements: $5,000
Although you received only $95,000 in cash, the property earned $100,000, so you may report taxable income based on the property's operations rather than simply the cash distributed. (This illustration is simplified; your actual taxable income would reflect operating expenses, mortgage interest (if it were a leveraged DST but not if it was a debt free DST) and depreciation.)
The $5,000 was not paid to the sponsor — it remained your money as part of the property's reserve account, along with the reserves attributable to the other DST investors.
Year 2
The property uses the reserve funds to:
- Replace the roof
- Resurface the parking lot
- Complete tenant improvements for a new lease
- Pay leasing commissions to secure a new tenant
Because you are a beneficial owner of the DST property, your proportional share of those capital expenditures is reflected in the property's tax reporting. Those expenditures generally create future tax benefits that help offset taxable income in later years, generally realized through depreciation and amortization over the assets' recovery periods.
The result: Although you may have paid tax on the additional $5,000 in Year 1 because it remained in reserves, those reserve dollars were ultimately invested back into the property for your benefit.
The associated future expenses help offset taxable income over time, making the difference between taxable income and cash distributions a matter of timing rather than a permanent additional tax burden.
The bottom line
The difference between DST cash distributions and taxable income is often misunderstood, but it is simply a reflection of how commercial real estate ownership has worked for decades regardless of if it is owned outright by the investor or by a DST.
Think back to the example of the landlord who owned a building and prudently retained a portion of rental income to build reserves for a future roof replacement. Although that owner received less cash in hand during the year, the reserve funds still belonged to the owner, remained invested in the property, and were ultimately used to preserve and enhance the value of the real estate.
Those expenditures ultimately generated expenses associated with those improvements, helping offset taxable income over time.
A DST simply follows that same long-established and widely accepted real estate ownership practice through a professionally managed ownership structure.
As always, because every investor's tax situation is unique, investors should consult their CPA or qualified tax adviser regarding the tax treatment of their individual DST investment.
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- What a Delaware Statutory Trust Can Do for Your Kids That Your Will Can't
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- DST Exit Strategies: An Expert Guide to What Happens When the Trust Sells
- How to Use DSTs and 1031 Exchanges for Diversification
- How Do You Step Away From Your Real Estate Empire Without Facing a Giant Tax Bill?
