Why DST Investors Think They're Overpaying Taxes
DST investors ask the same three tax questions about rental income, expenses, and why they're paying so much. Here's what's behind each one—and when to bring in a specialist.
EPC1031 Team
Along with our clients, DST sponsors and financial advisors regularly ask Exchange Planning Corporation—or refer their clients who ask—questions about the taxation of their DST investments. Three questions come up more than any others. If you work with DST investors, you should know the answers.
1. “Why Doesn’t the Rental Income Match My Distributions?”
Your rental income from a DST is made up of three parts: your distributions, expenses that are the investor’s responsibility, and in some cases a small contribution to reserves.
Your rental income minus expenses should approximate your distributions—but they won’t match exactly. One reason is that some sponsors set aside a small amount to add to reserves. The more common reason is timing differences. Distributions and expenses paid near year-end may land before or after December 31st, which can cause the distribution in either year to be more or less than what’s reflected in the rental income.
Even if distributions were reduced or paused in a particular year, the investor would still report income from their share of expenses. Over time, distributions even out. Rental income should eventually approximate the total of expenses paid plus distributions received.
Related: Exchange Planning Corporation explains how timing differences and reserve treatment affect DST taxable income in detail at epc1031.com/optimizing-tax-efficiency-dsts
2. “Why Aren’t There More Expenses to Deduct?”
In a DST, expenses are treated differently depending on the agreement between the investors and the DST sponsor. Each sponsor determines which expenses the investors will be responsible for and which expenses the Master Tenant that operates the property will cover.
Some sponsors structure the DST so investors are only responsible for mortgage payments and a few minor management costs. Others make the investor responsible for a broader set of expenses. Either way, the net income reported is roughly the same.
If the sponsor structures the DST so investors pay only the loan payment, rental income will equal the loan payment plus distributions. If investors are responsible for additional expenses, the rental income reported will be higher—but so will the deductions. The bottom line doesn’t change. Every investor in every DST reports roughly the same net income whether they are liable for more or fewer of the operating expenses.
Related: Exchange Planning Corporation covers how reserve treatment affects deductions at epc1031.com/maximizing-tax-benefits-1031-exchanges-reserves
3. “Why Am I Paying So Much Tax on My DST Income?”
No one wants to pay more than they owe. With DSTs, it is very possible to structure the purchase of replacement properties so distributions are sheltered from taxes for many years. When a DST investor believes they’re paying too much, there are usually only two explanations.
The Exchange Wasn’t Reported Correctly
In more than half the cases Exchange Planning Corporation reviews, this is a problem, the exchange was not reported correctly. Most tax professionals—even very good ones—do not have the technical knowledge to report the exchange and claim the right amount of depreciation.
Determining depreciation on a replacement property after an exchange requires specialized tools and technical skill that most tax professionals simply don’t have. The tools don’t exist off the shelf. Exchange Planning Corporation had to develop proprietary software to maximize depreciation for our clients.
Related: Learn why even top CPA firms need specialized exchange expertise at epc1031.com/carryover-excess-basis-1031-explained-simply
The Property Selection Didn’t Prioritize Tax Savings
Occasionally, a DST investor will purchase properties that don’t produce significant tax savings—often because they weren’t aware that property and debt choices directly affect how much of their income can be sheltered.
For new clients—especially those with exchange equity over $1,000,000 and little or no debt—showing them how property selection and debt structure affect their future tax bill can be a game-changer. Exchange Planning Corporation’s “Understanding Property Choices and Debt” is a free tool at www.1031taxhub.com that generates a personalized report for each client, explaining how different property and debt choices will impact their taxes.
What You Can Do Today
If you have a client concerned about the amount of tax they’re paying on DST income, Exchange Planning Corporation is happy to perform an Exchange Review. We’ll make sure they aren’t overpaying. If they are, we often send them back to their tax professional armed with the documentation needed to reduce their taxes.
Attend our next webinar to see the financial planning calculators in action and learn how property choices affect investor tax bills. Register here.
Schedule a complimentary consultation: (424) 277-6011 | ExchangeServices@epc1031.com
Frequently Asked Questions
How common are 1031 exchange reporting errors? Exchange Planning Corporation’s reviews consistently show that nearly half of all 1031 exchanges contain reporting errors. Common mistakes include incorrect basis calculations, misreported closing adjustments, and improperly classified transaction costs—all of which reduce depreciation and inflate tax bills.
What is carryover basis and why does it matter for DST taxes? Carryover basis is the adjusted basis from your relinquished property that transfers to your replacement property in a 1031 exchange. It determines your depreciation deductions and future gain calculations. If carryover basis is calculated incorrectly, you could be losing thousands in annual depreciation—and overpaying taxes for years.
How do property choices and debt structure affect DST taxes? Debt increases your basis in the replacement property, which directly increases your depreciation deductions. Investors who choose higher-leverage DSTs and properties with favorable depreciation profiles can shelter more income from taxes. Property type, debt level, and cost segregation all play a role.
What is an Exchange Review from Exchange Planning Corporation? An Exchange Review is a comprehensive look at past exchanges to identify missed deductions, reporting errors, and tax recovery opportunities. Exchange Planning Corporation averages over $10,000 in savings per client and has recovered over $1.5 million in deductions annually.
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Disclosure: This content is provided for informational and tax-analysis purposes only. It does not constitute investment, financial, or legal advice and should not be relied upon to evaluate any specific investment, including DSTs, real estate offerings, or securities. Exchange Planning Corporation is not a registered investment advisor or broker-dealer. Please consult appropriate licensed professionals for investment recommendations and suitability evaluations.