What Happens to a DST Interest After an Investor Dies
A client who dies owning a Delaware statutory trust interest usually leaves the family a gift. For nearly every investor, the deferred gain from every prior exchange disappears at death. The heirs take the interest at its date-of-death value under Internal Revenue Code Section 1014. The job of the executor, the estate attorney and the advisor is to document the gift, transfer the interest to the right people and prevent anyone from giving it back.
That job is arriving on more desks every month. Investors put about $9.2 billion into DSTs in 2022 alone, and in my experience, most of them were at or near retirement when they bought. I run a fee-only advisory firm that works with DSTs every day, and the executor’s side of the investment is the part nobody explains at the closing.
The Documents
A DST is a trust that holds one or more income properties. A sponsor sets it up and sells beneficial interests to investors, most of whom arrive through an IRC Section 1031 exchange. For federal income tax purposes, the Internal Revenue Service treats each investor as owning an undivided share of the real estate itself, even though the interest is a security under securities law (Revenue Ruling 2004-86). That ruling is the reason the step-up works, and the reason the paper trail matters.
The executor should locate four things: (1) the trust agreement and private placement memorandum, which describe the property; the loan and the transfer rules; (2) the subscription agreement and the sponsor’s confirmation, which show how much the client bought and in whose name; (3) the closing file from the Section 1031 exchange that funded the purchase, including the qualified intermediary’s records; and (4) every annual operating statement since.
Most clients keep these in one folder from the closing. Many keep them nowhere. The sponsor and the qualified intermediary can replace what’s missing. The advisor who placed the investment usually has all four.
The Title
How the interest is titled decides where it goes. An interest held in the client’s own name goes through probate, under the will or by intestacy. An interest held in a revocable living trust passes under the trust and skips probate. An interest held by a single-member limited liability company passes with the LLC. An interest held jointly with a spouse passes by survivorship.
The subscription agreement states the titling. Read it before assuming anything. An interest the surviving spouse already owns shouldn’t sit in probate because nobody checked.
Titling also sets the size of the step-up. A married couple in a community property state gets a new basis on the whole interest at the first death. A couple holding as joint tenants in a common law state gets it on half.
One more point for the estate attorney. Delaware law (Del. Code Ann. tit. 12, Section 3805(c)) treats the beneficial interest as personal property, even though the IRS treats it as real estate for income tax purposes. A DST holding buildings in three states shouldn’t trigger ancillary probate in any of them. The interest is governed by the law of the client’s domicile.
The Transfer
Every sponsor has its own transfer process for a deceased investor. The core package is a death certificate, letters testamentary or a trust certification, and the sponsor’s assignment form signed by the executor or trustee. If the property carries a loan, the executor can leave it alone. The sponsor arranged it at syndication, and it sits at the trust level. The heirs never signed for it, never qualified for it and don’t need the lender’s permission to inherit.
Monthly distributions don’t stop when the investor dies. They keep going to the account on file until the sponsor records the new owners, so the executor should redirect them to the estate account early and track them for the fiduciary return.
The Valuation
The estate needs a date-of-death value for the interest, and the sponsor is the place to start. Most sponsors publish a per-interest value at least once a year because custodians require one for retirement accounts.
For a taxable estate, or any estate where the step-up is worth serious money, I recommend an independent appraisal of the beneficial interest. It supports Form 706 and the basis the heirs will depreciate for years.
The Tax File
A DST doesn’t issue a Schedule K-1. The sponsor sends a grantor letter and an operating statement reporting the investor’s share of rent, expenses, interest and depreciation, which the accountant uses for the client’s final Form 1040 and the estate’s Form 1041.
After the step-up, the heirs start depreciating the property at its new basis. The old depreciation schedule, the old exchange history and the recapture that was hanging over the client all go away. If the estate is required to file a Form 706, the executor must also furnish Form 8971 and its Schedule A so that the basis the heirs use matches the value the estate reported (IRC Section 6035; IRS, Instructions for Form 8971 and Schedule A).
The Beneficiaries
Most DST interests can’t be redeemed. Some sponsors are the exception. Their trust agreements allow the estate or heirs to redeem the interest at death at its current net asset value, and that’s the first question I’d put to the sponsor. Without that provision, the sponsor sells the property when the market allows, typically five to 10 years after the offering. A beneficiary who needs cash now won’t get it from the DST.
Where there’s no redemption right, the executor has two tools. The first is distributing the interest in kind. Most trust agreements allow the estate to split an interest among the beneficiaries, subject to the sponsor’s minimum interest size, so each heir holds a smaller interest with its own stepped-up basis and its own monthly check. The second is meeting cash needs from other estate assets and leaving the DST to the heirs who can wait.
When the DST eventually sells, each heir’s gain is measured from the date-of-death value, less any depreciation taken since, not from the property the client sold 20 years earlier. Each can take the cash or exchange it for another property and continue. Either way, the client’s planning worked.
Not an OP Unit
One caution. A DST that converted into operating partnership units of a real estate investment trust through an IRC Section 721 contribution is a partnership interest, not real estate. The step-up still applies, but the transfer, reporting and liquidity are different enough that this checklist doesn’t fit. That’s a separate article.
Advisors can make the executor’s job short before it starts. Keep a one-page inventory with the client’s estate documents, including the sponsor, the registered owner, where the subscription file is kept, who placed the investment and when the money comes out. Then ask the client who will find it.
The sponsor manages the real estate. Someone still has to manage the handoff.
