Depreciation plays a crucial role in controlling taxable income for DST investors. It is important to note that depreciation is not calculated on a pro-rata basis but rather on each individual owner’s basis. Basis refers to the investor’s adjusted cost in the property and is essential in understanding the need for debt and its impact on tax planning.
To grasp the concept of basis and its importance, it may be beneficial to schedule a phone conference with an experienced professional who can provide further clarification and insights tailored to your specific situation. Understanding basis is vital in comprehending the correlation between debt, basis, depreciation, and tax implications.
Treatment of Expenses in DSTs
DSTs are designed to be passive investments, and there are limitations on the ability to make significant improvements or refinance the properties within the trust. However, the treatment of expenses in DSTs can vary depending on the sponsors or the attorneys involved in setting up the trusts.
Some sponsors may allocate only specific expenses such as mortgage interest and property taxes to the beneficial owners, while others include additional expenses like insurance. It is crucial to note that any expenses allocated to the beneficial owner are also factored into the rental income reported by the owner.
Timing Differences and Taxable Income
Due to timing differences between income receipts and expense payments, investors may not pay taxes solely on their distributions, reserve contributions, less depreciation each year. However, over time, taxable income tends to align closely with distributions plus reserve contributions minus depreciation.
This understanding is significant for investors, as the only control they have over the difference between distributions and taxable income is through depreciation, which is influenced by basis. Before investing in replacement properties through DSTs, it is essential for investors to comprehend how debt affects basis and depreciation to effectively manage their tax obligations. The suitability of increasing debt and basis may vary depending on an investor’s tax bracket and income level.
Treatment of Reserves
There is ongoing industry debate surrounding the treatment of reserves within DSTs. At EPC, we believe the most tax-efficient approach is to exclude reserves from the purchase price of the DST. This exclusion allows the expenses paid from reserves to be deducted from distributions. Conversely, including reserves in the purchase price results in the reserves becoming part of the basis and subject to depreciation, thereby eliminating the deduction for expenses paid from reserves.
When sponsors add additional reserves and include them in rent after the initial funding, it becomes challenging to determine whether the expenses paid are deductible or not. Excluding the reserves from the initial funding allows for clarity in distinguishing between deductible and non-deductible expenses.
Optimizing Tax Efficiency and Addressing Critical Issues
To achieve maximum tax efficiency, it is crucial to understand the treatment of all income and expenses within a specific DST. Proper comprehension of depreciation, basis, reserves, and expense allocation enables investors to make informed decisions and strategically manage their tax obligations.
Partnering with a knowledgeable 1031 exchange specialist, such as Exchange Planning Corporation, is paramount in navigating the complexities of DSTs and maximizing tax benefits. Our experts stay up to date with the latest regulations and provide personalized guidance tailored to your unique needs, ensuring you make informed investment decisions and optimize tax efficiency.
FAQ
Q: How does basis impact tax planning in DSTs?
A: Basis plays a crucial role in determining taxable income in DSTs. Understanding basis allows investors to utilize depreciation to control their tax obligations and optimize tax efficiency.
Q: What is the treatment of expenses in DSTs?
A: The treatment of expenses in DSTs can vary depending on the sponsors or attorneys involved. It is important to understand which expenses are allocated to the beneficial owner and how they impact rental income and taxable income.
Q: What is the controversy surrounding the treatment of reserves in DSTs?
A: There is ongoing debate about whether reserves should be excluded from the purchase price of DSTs. Excluding reserves allows for deduction of expenses paid from reserves, while including reserves in the purchase price eliminates the deduction for these expenses.
Q: How can Exchange Planning Corporation help in maximizing tax benefits in DSTs?
A: Exchange Planning Corporation specializes in 1031 exchanges and DSTs. Our experts provide personalized guidance, staying up to date with the latest regulations and assisting investors in optimizing tax efficiency and making informed investment decisions.
