Plenty of dentists end up owning their building by accident. We had a client whose landlord let the shopping center just go downhill. They ran the numbers on a standalone building in the same area and found the write-off would pretty much pay for their down payment, so they bought it.
Give it fifteen or twenty years and a building like that turns into one of your biggest assets, and a second job. When you sell the practice, you have to decide what happens to it, and a Delaware statutory trust 1031 exchange is an option dentists ask us about a lot.
Still deciding whether to buy your building at all? Start with our post on real estate strategies for dentists. This one is about the back end, and since DST interests are securities, picking one is a conversation for you and a licensed investment professional.
What Is A Delaware Statutory Trust And Why Do Dentists Use It At Practice Exit?
A DST is basically a big building (or a few of them) that a company called a sponsor buys and manages, and you buy a slice of it. The buildings are usually net-leased, meaning the tenant pays the property taxes, insurance and upkeep.
In Rev. Rul. 2004-86, the IRS looked at a DST holding a net-leased property. It concluded that each investor is considered to own a fractional piece of the real estate itself for federal income tax purposes.
Because you own a slice of the property itself, the interest can count as replacement property, meaning whatever you buy with the money from the building you sold.
We tell dentists who own real estate to keep trading up every five years or so. When you sell, do a 1031 exchange and follow the rules exactly so you don’t pay tax on the gain. A DST is one way to keep that going after you’ve hung up the handpiece.
Most of the dentists who ask us about DSTs are tired of being a landlord. They want the real estate money without the 9 p.m. call about the roof.
How a DST Works As Replacement Property Inside A 1031 Exchange
A DST fits because a qualifying DST interest is treated as real estate, and Section 1031 now applies only to exchanges of real property. That limit matters a lot for dentists.
Your chairs, imaging and sterilizers can’t ride along, because the IRS says exchanges of equipment and intangible business assets generally don’t qualify. That rules out goodwill too, so the building is the one piece of your exit that can go through the exchange.
The owner on the deed generally has to be the owner on the exchange. If the building sits in an LLC with your spouse or a partner, plan on that LLC doing the exchange, and talk to us before anyone moves the title around.
The sale money goes to a qualified intermediary, a neutral company that holds it so you never touch it. The Form 8824 instructions treat an exchange run that way as a like-kind exchange, and the intermediary uses the funds to buy your DST interest.
The ruling also limits the trust. The trustee can’t renegotiate the lease or the loan and can make only minor changes, so a DST runs on autopilot and can’t adapt much if the tenant or market changes.
Why Do Dentists At Exit Choose A DST Over Keeping The Building?
Most dentists at exit want to keep the money the building made them and stop managing it. Keeping it means years as landlord to whoever bought your practice, plus the parking lot and the HVAC unit that always dies on a holiday weekend.
Selling outright is cleaner, but the tax generally lands in the year of sale. Some of it is on the building’s appreciation. Some of it is on the depreciation you took on the building over the years, which comes back as unrecaptured section 1250 gain, taxed at up to 25%.
If you’re carrying a note on the practice, that gain can sometimes be spread out, as we cover in selling a dental practice on an installment sale. The building is a separate decision.
A DST lets you trade the building for passive real estate and defer that gain, as long as the exchange rules are met. You can also split the money across more than one DST holding different property types or regions, which a single dental building can’t give you.
Keep in mind the tax is deferred, so the gain carries into the DST and comes due when that interest is eventually sold. We tell clients real estate is usually a tax-reduction play before it’s a return play, and a DST is a tax-deferral decision first and an investment second.
Cost Segregation Changes The Math On Your Building
Let’s look at an example from our own client work. A dentist with two successful offices came to us with a huge estimated tax bill, and he owned the real estate under both. As we wrote up in our dentist real estate case study, we brought in partners to do a cost segregation study and wrote off a portion of the buildings much faster.
A cost seg study splits parts of a building, like cabinetry and certain wiring, off the building’s long schedule onto shorter ones. Those split-out pieces are section 1245 property, and when you sell, that depreciation is recaptured as ordinary income rather than the building rate of up to 25%.
Some of those pieces may also count as personal property instead of real property, and personal property can’t go through the exchange. So if you did a cost seg study, we check which components actually qualify before the exchange, so the tax bill doesn’t surprise you after closing.
Cash Flow And Depreciation Inside A DST: What You Actually Receive
You receive a share of the property’s net rental income and its deductions, including depreciation. Under Rev. Rul. 2004-86, investors report their portion of the trust’s income, deductions, and credits on their own returns, so a DST behaves a lot like owning the building did, minus the phone calls.
Distributions depend on how the property performs and aren’t guaranteed. The depreciation doesn’t restart at the full price of the interest, either. The Form 8824 instructions have you figure the basis of the like-kind property you receive as part of the exchange, and that carried-over basis drives what you can deduct going forward.
We run that math before the exchange, because it’s a lot easier to adjust a plan than a closed deal.
DST vs REIT: Why The Difference Matters In A 1031 Exchange
REIT shares don’t work as 1031 replacement property, and a qualifying DST interest can. A REIT is a company, so its shares are stock, and stock doesn’t count as real property no matter how many buildings the company owns. So you can’t sell the building, buy a REIT fund, and call it an exchange.
REITs do have one thing DSTs lack. Publicly traded REIT shares can generally be sold on any trading day, while a DST interest usually has no ready market and is held until the sponsor sells the property.
If flexibility matters more to you than deferral, paying the tax and buying something you can sell easily can be the better trade. We model that option with you too. If deferral still wins, the next decision is timing, because the exchange runs on two clocks.
The 45-Day And 180-Day Windows That Govern A 1031 Exchange Into A DST
The two deadlines start when you transfer your building, and they don’t stretch to fit a busy hygiene schedule. Per the Form 8824 instructions, you have to identify the replacement property within 45 days after the building is transferred. You have to receive it within 180 days, or by the due date of your tax return including extensions, whichever is earlier.
That “whichever is earlier” catches people. Sell late in the year, and your return due date can land before day 180 unless you extend. The identification also has to be in writing.
DSTs are popular with existing dentists partly because of these clocks. A DST offering already has the property and financing lined up, so it’s easier to close in time than hunting for a building yourself. An offering can still fill up before your money arrives, which is why we like a backup identification. Most of the mistakes we see tie back to these clocks, so let’s go through them.
What Mistakes Do Dentists Make When Using a DST at Practice Exit?
The first mistake is starting the conversation after the building is under contract, when the 45-day clock is about to start, and the DST gets picked under pressure.
The second is touching the money. If you receive cash or other property in the exchange, the IRS says you must recognize a gain to the extent of what you received. Pulling some cash out for retirement means part of the gain is taxed now, and taking on less debt than you paid off can create a taxable difference too.
The third is underestimating how long the money is stuck. DST interests are securities, and FINRA’s guidance on tenancy-in-common interests, a close cousin of DSTs, says there’s no known secondary market for them and that fees can eat into the value of the deferral. Plan on that money being tied up until the property sells.
The fourth is skipping the investor requirements. DST offerings are commonly private placements, sold directly to investors instead of on a public exchange, and usually limited to accredited investors under SEC Rule 501, which sets net worth and income tests.
The fifth is planning the building on its own. The building sale, the practice sale and your post-exit cash flow hit the same tax years, which is why we fold DST planning into our dental tax strategy and dental CFO services for owners heading toward a sale.
If you own your building and a sale is on the horizon, book a call with Virjee Consulting and we’ll walk through your numbers before any clock starts.
If you liked this, you might also like: Tax Consequences of Selling a Dental Practice
About the Author
Omar Virjee, CPA is the founder of Virjee Consulting, a CPA firm specializing in year-round tax planning and monthly bookkeeping for solo and small-group dental practice owners across the United States. Omar focuses on helping dentists maximize owner take-home pay through proactive tax strategy, S-Corp optimization, dental real estate planning, and clear monthly financials.
Meet Omar · Schedule a Consultation
Getting owner pay right is half tax question and half payroll mechanics, and our dental payroll services cover the mechanics side.
