DST vs a Mortgage or Real Estate Debt Fund: Equity Deferral or Interest Income

With exchange proceeds there is no choice to make, because a debt investment is not real property

Section 1031(a)(1) defers gain only when real property is exchanged for real property. Reg. section 1.1031(a)-3(a)(5) lists intangibles that are never real property: stock, bonds and notes, other securities and evidences of indebtedness, partnership interests, and certificates of trust or beneficial interests.

A mortgage note is a note. A debt fund is usually an LLC or limited partnership, which is a partnership interest, or a REIT, which is stock. All of them fail. If your intermediary pays exchange money into one, the exchange ends and the gain is taxed.

A Delaware Statutory Trust works differently. Rev. Rul. 2004-86 treats each investor as owning an undivided fractional interest in the trust's real estate, so it is real property for exchange purposes. That is the only side of this comparison that can take exchange dollars.

For after-tax cash, the tax character of the income is the first difference

Interest is ordinary income, taxed at your top bracket, and section 1411 counts it as net investment income for the 3.8% tax once modified AGI passes $250,000 joint or $200,000 single. A fund that lends against real estate has no buildings of its own to depreciate, so nothing offsets that interest.

A DST owner reports a share of the trust's rent, interest expense and depreciation as if owning the property, which the ruling grounds in the grantor trust rules. Depreciation can offset part of the income, at the cost of recapture when the property is sold.

If the debt vehicle is a REIT, ordinary dividends that are neither capital gain dividends nor qualified dividend income are qualified REIT dividends under section 199A(e)(3), eligible for a 20% deduction. A private debt fund organized as a partnership passes through interest instead.

Worked model: $10,000 of income taxed two ways

Hypothetical round numbers for an investor in the 32% bracket and above the net investment income tax threshold. The amounts show tax character only; they are not projections of what either investment pays, and both can pay less or nothing. Run your own numbers with your CPA.

• Debt fund interest of $10,000: all ordinary, so 32% plus 3.8% is $3,580 of federal tax.
• DST distributions of $10,000, with a hypothetical $4,000 of the trust's depreciation allocated to you: $6,000 taxable at 32% plus 3.8% is $2,148.
• The $4,000 of depreciation lowers your basis and comes back as recapture when the trust sells, unless you exchange again or hold until death.
• If the debt vehicle were a REIT paying qualified REIT dividends, the 20% deduction would cut the amount subject to income tax to $8,000.

Risk position: the lender is paid first but capped, the owner is paid last but keeps the upside

A mortgage lender's return is limited to the interest and fees in the loan. It is repaid ahead of the owner, and if a borrower defaults the lender's remedy is the collateral, which can mean foreclosure costs, delays and a recovery below the loan balance.

An equity owner, including a DST investor, takes what is left after debt service: rent growth and appreciation go to the owner, and so do vacancies and price declines. DST risks are summarised in DST key risks, and leverage inside the trust adds to them, as covered in DST leverage and interest rate risk.

Both are usually private offerings sold to accredited investors under 17 CFR 230.501(a), and both are generally illiquid. Read the redemption terms of a debt fund and the hold period of a DST before investing either.

The questions that separate one offering from another matter more than the label

Two debt funds can carry very different risk, and so can two DSTs. Ask for the answers in writing, from the offering documents rather than a summary, before any money moves.

• Debt fund: lien position of the loans (first or junior), loan-to-value at origination, how much the fund itself borrows, how often and on what terms investors can redeem, and every fee charged at the fund and loan level.
• DST: who the tenants are and when their leases end, the amount, rate and maturity of the trust's loan, the sponsor's fees at purchase, during the hold and at sale, and the expected hold period.
• Both: what happens in a default or vacancy, who decides, and whether you can be asked for more money. The trust agreement in Rev. Rul. 2004-86 bars the trustee from accepting additional contributions, including money; many funds can call capital.
• Both: what tax documents you will receive, and when, so your CPA can plan for them.

Where each fits: exchange money to the DST, after-tax money wherever the income and risk suit you

If the money is in an exchange, the answer is a DST or other real property; DST like-kind qualification covers what makes a trust qualify. If the exchange has failed or the leftover cash has already been taxed, the decision is open, and DSTs bought without a 1031 explains how cash buyers participate.

A debt fund suits a cash investor who wants a contractual income stream and a senior claim, and accepts ordinary rates and no growth. A DST suits one who wants real estate ownership, depreciation and the option to exchange later. Owners who carry a note for their own buyer face the same rule: the note is not like-kind.

For leftover exchange gain specifically, a qualified opportunity fund can defer the tax, which neither a debt fund nor a cash DST purchase does; see leftover boot: QOF or another DST.