How Delaware Statutory Trust Depreciation Works

A Delaware Statutory Trust (DST) offers a way to own a fractional interest in a portfolio of professionally managed real estate. For tax purposes, the IRS treats a DST investment as direct property ownership, allowing investors to benefit from tax advantages like the deduction for depreciation. Depreciation is an annual tax deduction that allows investors to recover the cost of an income-producing property over its designated useful life. This non-cash expense accounts for the presumed wear and tear on physical structures and improvements, reducing an investor’s taxable income.

Determining Your Depreciable Basis

An investor’s depreciable basis is the starting point for calculating annual depreciation deductions. This figure represents the portion of the total investment allocated to the physical building and other improvements, as land itself cannot be depreciated.

For an investor making a cash purchase, the initial basis is the amount paid for the DST interest, less the value of the underlying land. For example, if an investor pays $200,000 for a DST interest and the sponsor’s documentation indicates that 20% of the trust’s asset value is land, the initial depreciable basis would be $160,000.

The calculation is different when an investor uses a DST as a replacement property in a 1031 exchange. In this scenario, the depreciable basis from the relinquished property, known as a “carryover” basis, transfers to the new DST interest. If the investor also contributes additional cash, or “boot,” that amount is added to the carryover basis to establish the new total depreciable basis.

The sponsor provides each investor with a statement that clearly allocates the purchase price among land, the building, and any other depreciable components. This information is used to accurately establish the depreciable basis.

Calculating and Claiming the Deduction

Once the depreciable basis is established, the annual depreciation deduction is calculated using the Modified Accelerated Cost Recovery System (MACRS). This is the mandatory system for most tangible property placed in service after 1986. Under MACRS, the IRS assigns specific recovery periods to different types of property, which is most commonly 27.5 years for residential rental properties and 39 years for commercial properties held within a DST.

The annual deduction is determined by dividing the investor’s depreciable basis by the applicable recovery period. For instance, an investor with a $390,000 depreciable basis in a commercial property would be entitled to a $10,000 annual depreciation deduction ($390,000 / 39 years). This deduction is claimed each year of the recovery period.

Investors do not need to perform these calculations themselves, as the DST sponsor manages the property’s accounting. The sponsor provides each investor with an annual “grantor trust letter.” This document details the investor’s pro-rata share of all income and expenses, including the specific amount of the depreciation deduction for that tax year.

To claim the deduction, the amount provided by the sponsor is reported on the investor’s tax return. The total depreciation is calculated on IRS Form 4562, Depreciation and Amortization. The figure from Form 4562 then flows to Schedule E (Supplemental Income and Loss), where it is used to offset the rental income generated by the DST.

The Impact of Cost Segregation

Many DST sponsors enhance depreciation benefits by commissioning a cost segregation study. This engineering-based analysis identifies building components that can be reclassified into categories with shorter recovery periods. Instead of depreciating all structural components over 27.5 or 39 years, a study separates items like carpeting and specialty lighting, which can be depreciated much faster.

Assets identified in the study are often reclassified as personal property with a recovery period of 5 or 7 years. Other items, such as parking lots and landscaping, are considered land improvements and are depreciated over 15 years.

A benefit of this reclassification is that assets with a recovery period of 20 years or less are eligible for bonus depreciation. For assets placed in service in 2025, this allows for an immediate 40% deduction of the asset’s cost. This rate is scheduled to decrease to 20% in 2026 before being eliminated.

For example, on a $1 million depreciable basis, a cost segregation study that reclassifies 20% ($200,000) to property eligible for 40% bonus depreciation could provide an immediate deduction of $80,000 from those assets alone. This dramatically increases the first-year tax shield compared to the standard deduction.

This accelerated deduction does not increase the total depreciation claimed over the property’s life; it simply changes the timing. Shifting deductions forward increases the property’s after-tax cash flow in the initial years of ownership.

Depreciation Recapture in a DST Context

When the property held by the DST is sold, the IRS uses depreciation recapture to tax the gain attributable to depreciation claimed during the holding period. Every dollar of depreciation taken reduces an investor’s cost basis, which increases the total taxable gain realized upon its disposition.

The gain created by the reduced basis is not taxed at preferential long-term capital gains rates. The portion of the gain from depreciation is classified as “unrecaptured Section 1250 gain” and is taxed at a maximum federal rate of 25%. Any remaining gain above the total depreciation taken is treated as a long-term capital gain.

Upon the sale, the DST sponsor provides each investor with a final tax statement. This document specifies the investor’s share of the total gain, distinguishing between the amount subject to the 25% recapture rate and the portion qualifying for capital gains treatment.

An investor can defer the recaptured depreciation and capital gain by rolling the proceeds into another 1031 exchange, potentially into a new DST. This strategy allows for continued tax deferral, but the recapture liability carries forward into the next investment.