Return of Capital vs Income in DST Distributions

A grantor trust passes items through, so the cash distribution is not itself taxed

Rev. Rul. 2004-86 classifies the DST it describes as a grantor trust and explains that a person treated as owner of an undivided fractional interest of such a trust is considered to own the trust assets attributable to that interest. Section 671 then puts that owner's share of the trust's income, deductions and credits on the owner's own return. Rent the trust collects is your rent; the mortgage interest it pays is your interest; the building's depreciation is your depreciation.

That is why a DST statement does not look like a partnership K-1 with a distribution line that reduces basis. Under Reg. section 1.671-4 the trustee gives each grantor a statement showing the items of income, deduction and credit attributable to that owner and the information needed to compute taxable income. Moving cash from the trust's account to yours changes nothing for tax purposes, because for tax purposes it was already yours.

The phrase return of capital comes from partnership and REIT reporting, where a distribution in excess of earnings reduces basis. Prior-performance tables in REIT prospectuses filed with the SEC use it in exactly that sense, with a line for distributions from "Other (return of capital)". It is the wrong frame for a DST, where the right question is how taxable income compares with cash.

Depreciation is what makes taxable income lower than cash, and it lowers your basis by the same amount

Depreciation is a deduction with no cash outflow. If the trust's rent covers interest, expenses and a distribution, and depreciation is then deducted on top, your taxable share can be well under the cash you received, or even a loss. That gap is what marketing materials call sheltered or tax-advantaged income.

The gap is not free. Section 1016(a)(2) reduces basis for depreciation allowed, but not less than the amount allowable, and IRS Publication 551 lists depreciation among the decreases to basis. Lower basis means more gain when the trust sells. Under IRS Topic 409, the unrecaptured section 1250 portion of that gain is taxed at a maximum 25% rate, and net investment income tax can apply on top.

If you bought the interest in an exchange, your depreciation is not simply the trust's figure scaled to your share. Reg. section 1.168(i)-6 splits your basis in replacement property into an exchanged basis, generally depreciated over the relinquished property's remaining schedule, and any excess basis, treated as newly acquired. Your CPA builds that schedule from your own records; depreciation and bonus depreciation in DSTs covers the choices.

The reverse also happens: cash the trust keeps for principal or reserves is taxed without being paid

Loan principal is not deductible, and neither is a deposit to a reserve. When rent pays them, you report the income without receiving the cash. A filed prospectus supplement from a non-traded REIT, reporting the prior performance of a single-tenant office DST in its Table III, shows the pattern. For 2014 the program reported tax-basis income from operations of $115.34 per $1,000 invested, with depreciation not computed because, as the table's notes explain, each investor's exchange basis is different, and cash distributions of $65.00 per $1,000, all characterized on a tax basis as investment income and none as return of capital. The program generated $1,845,433 of cash and distributed $1,040,000.

Those figures are one past program, not a pattern to expect; the table itself states that past performance is not necessarily indicative of future results. They show the mechanics: what you report depends on the trust's income and your depreciation, and what you receive depends on what the trustee decides is available after debt service and reserves.

A hypothetical year shows the two numbers side by side

Hypothetical, rounded: your share of a trust's rent is $40,000. Your share of mortgage interest is $12,000 and of trust expenses and fees $3,000. The trust pays no principal that year and holds nothing back, so you receive $25,000. Your depreciation on your own basis is $15,000. Your taxable rental income is $10,000, and $15,000 of the cash was sheltered.

After three such years your basis is $45,000 lower than when you started. If the trust then sells in a taxable sale, that $45,000 returns as gain taxed at up to 25%, plus any net investment income tax. If you exchange your share into another property instead, the gain is deferred and the lower basis carries over, as explained at basis in replacement property after a 1031. Run your own numbers with your CPA; the figures here are illustrative only.

Distributions are not assured in any year. The cash figure can fall or stop while the taxable figure continues, as described at DST distribution cuts and suspensions.

Reading the grantor statement: three lines to reconcile against your bank deposits

Start with gross rents and the deductible expenses, including interest, that produce net rental income before depreciation. Then compare the year's distributions you actually received. The difference is principal, reserve movements and timing. Then apply your own depreciation, which may differ from any figure the sponsor provides because your basis is yours.

Ask the sponsor three questions each year: how much loan principal was paid, how much was added to or drawn from reserves, and whether any distribution was funded from reserves set aside at the offering rather than from operations. The full form-by-form walk-through is at DST tax forms and reporting, and the federal return mechanics at DST tax return reporting.