Case Study, Uncategorized

DST vs. 1031 Exchange: Which Strategy Wins for Long-Term Income Security?

March 4, 2025 No comments yet

For property investors approaching retirement, the decision between a Deferred Sales Trust (DST) and a 1031 Exchange can significantly impact your financial future. Both strategies offer tax deferral benefits, but their structures create fundamentally different outcomes for those seeking long-term income security.

Understanding the Basics: DST vs. 1031 Exchange

What is a Deferred Sales Trust?

A Deferred Sales Trust is an installment sale strategy that allows sellers of appreciated assets to defer capital gains tax while converting their equity into an income-producing investment portfolio. The seller becomes the beneficiary of a trust that can be structured to provide customized income payments throughout retirement.

What is a 1031 Exchange?

A 1031 Exchange (named after Section 1031 of the IRS tax code) allows investors to defer capital gains taxes when they sell an investment property and reinvest the proceeds in a “like-kind” property of equal or greater value within specific timeframes.

Real Numbers: How Each Strategy Affects Your Retirement Income

Let’s examine a realistic scenario to illustrate the differences:

Example: John owns a rental property worth $1.5 million with a cost basis of $500,000

Scenario A: 1031 Exchange

  • John exchanges into a $2 million property requiring a new mortgage of $500,000
  • Estimated annual rental income: $120,000 (6% cap rate)
  • Annual expenses including property management, maintenance, insurance, and property taxes: $48,000 (40% of income)
  • Annual mortgage payment: $30,000
  • Net annual income: $42,000 (2.8% cash-on-cash return)
  • John still has property management responsibilities or costs

Scenario B: Deferred Sales Trust

  • John sells the property for $1.5 million and places proceeds in a DST
  • No immediate capital gains tax on the $1 million gain
  • Trust invests in a diversified portfolio averaging 7% annual returns
  • Structured distribution of $90,000 annually (6% of principal)
  • Net annual income: $90,000 (6% cash-on-cash return)
  • No property management responsibilities
  • Ability to adjust income based on needs

Pros and Cons Analysis

1031 Exchange Pros:

  • Continued potential for property appreciation
  • Leverage opportunity through mortgage financing
  • Potential to reset depreciation schedule
  • Familiar strategy for real estate investors
  • Unlimited exchanges possible throughout lifetime

1031 Exchange Cons:

  • Limited to “like-kind” real estate investments
  • Strict 45-day identification and 180-day closing deadlines
  • Ongoing property management responsibilities
  • Typically lower cash flow yields (2-4%)
  • Concentration risk in a single asset class
  • Must take on equal or greater debt

Real-life example: Michael, 65, completed a 1031 exchange from a $900,000 apartment building into a $1.2 million NNN lease property. While he escaped immediate taxation on his $400,000 gain, his annual income decreased from $54,000 to $48,000 due to the lower cap rate on the replacement property. Additionally, when commercial real estate values declined 15% during a recession, Michael found himself with limited options due to his concentrated position.

DST Pros:

  • Greater investment diversification possibilities
  • Customizable income schedule
  • No property management responsibilities
  • Higher cash flow potential (5-8%)
  • No deadlines for reinvestment
  • No requirement to maintain or increase debt
  • Ability to convert to Roth IRA over time through strategic distributions

DST Cons:

  • Complex structure requiring specialized expertise
  • Setup costs typically range from $10,000-$25,000
  • Loss of potential direct real estate appreciation
  • Interest earned in trust is taxable
  • Less familiar strategy for many investors and advisors

Real-life example: Barbara, 62, sold her rental portfolio worth $2.1 million with a cost basis of $800,000. Rather than exchanging into more properties, she placed the proceeds in a DST. The trust was structured to provide $126,000 annually (6% of principal), with a portion of each payment representing tax-free return of principal. This provided Barbara with $10,500 monthly income without property management responsibilities, while the trust’s principal continued growing at approximately 3% annually after distributions.

Which Strategy Best Supports Long-Term Income Security?

For Active Investors (Under 60)

The 1031 Exchange often makes more sense for younger investors who:

  • Want to continue building their real estate portfolio
  • Have the energy and desire to manage properties
  • Value appreciation potential over immediate cash flow
  • Have other income sources and don’t need liquidity

For Income-Focused Investors (Over 60)

The Deferred Sales Trust typically provides better income security for those who:

  • Prioritize steady, predictable cash flow
  • Want to diversify beyond real estate
  • Prefer passive investments over active management
  • Need flexibility in distribution timing and amounts
  • Want to reduce concentration risk

Case Study: The McDonalds’ Retirement Transformation

James and Linda McDonald, both 67, owned three rental properties worth a combined $2.2 million with a total cost basis of $900,000. They were earning approximately $88,000 annually (4% return) but spending 15-20 hours weekly on property management.

Option 1: 1031 Exchange They considered exchanging into a portfolio of NNN properties, which would have:

  • Required them to identify suitable replacement properties within 45 days
  • Produced approximately $99,000 annual income (4.5% cap rate)
  • Eliminated most but not all management responsibilities
  • Kept them concentrated in commercial real estate

Option 2: Deferred Sales Trust They ultimately chose a DST structure that:

  • Provided $132,000 annual income (6% distribution rate)
  • Created complete freedom from property management
  • Diversified their assets across multiple investment classes
  • Included provisions for increasing distributions to offset inflation
  • Established a legacy plan for their children

Five years into retirement, the McDonalds report the DST increased their income by $44,000 annually while eliminating property management stress, allowing them to travel extensively and enjoy retirement without property concerns.

Hybrid Approaches: Getting the Best of Both Worlds

Some investors find a combination strategy works best:

  1. Use 1031 exchanges during wealth accumulation years
  2. Convert to a DST for the final sale when transitioning to retirement
  3. Structure the DST to include some real estate investments for diversification
  4. Create a laddered income approach with increasing distributions over time

Conclusion: The Decision Comes Down to Your Retirement Goals

The choice between a DST and 1031 Exchange ultimately depends on your personal retirement income needs:

  • Choose a 1031 Exchange if: You want to remain active in real estate, value potential appreciation over immediate income, and aren’t concerned about asset concentration or management responsibilities.
  • Choose a Deferred Sales Trust if: You prioritize higher immediate cash flow, desire investment diversification, want to eliminate property management, and need customizable income options throughout retirement.

Before making this critical decision, consult with financial advisors experienced in both strategies who can provide analysis specific to your situation, tax implications, and long-term income goals.