There are several reasons why long-term property owners may decide to sell. Many want to unlock equity that has built up over the years to reinvest in other opportunities or fund major life events. Others are looking to reduce concentration risk, choosing to diversify their holdings rather than keeping too much capital tied up in a single asset or market. This is where a 1031 Exchange and Delaware Statutory Trust (DST) come in to sell and invest in a more tax-efficient manner.
Some owners, especially those nearing retirement, want to step away from the responsibilities of being a landlord, freeing themselves from property management headaches. Additionally, concerns like climate change, shifting local regulations, rising insurance costs, or economic changes can make holding onto a property less attractive.
Whether for financial, lifestyle, or risk-management reasons, selling a long-held property can be a strategic move to maximize returns and reduce future uncertainties. However, selling a property can come at a significant financial cost.
Taxes Consequence of Selling Real Estate
Selling real estate can oftentimes result in a 30-40% tax consequence. The amount you owe depends on factors such as how long you’ve owned the property, whether it was a primary residence or an investment, and your overall income level. Federal and state capital gains taxes, depreciation recapture, and local transfer taxes can all add up, often consuming a substantial portion of your profits.
Seeking a tax advisor to understand the potential tax obligations in advance is essential so investors can plan strategically to minimize their tax liability and maximize their returns. Below are potential taxes to consider when selling a business or investment property.
- Federal Capital Gains Tax – Short-Term Capital Gains Tax (STCG) (held for less than 1 year): Taxed as ordinary income at federal rates ranging from 10% to 37%, depending on your tax bracket.
- Net Investment Income Tax (NIIT) – An additional 3.8% tax applies to capital gains if your Modified Adjusted Gross Income (MAGI) exceeds: $200,000 (single filers), $250,000 (married filing jointly)
- State Capital Gains Tax
There can also be capital gains tax at the state level. For example, California treats all capital gains as ordinary income, meaning there is no distinction between short-term and long-term capital gains.
The tax rate ranges from 1% to 13.3%, depending on your state income tax bracket.
Depreciation Recapture Tax
If you claim depreciation on a rental or investment property, the IRS requires you to recapture that amount at a fixed 25% tax rate.
Property Transfer Taxes (County/City Level)
County Transfer Tax: Typically $1.10 per $1,000 of the sale price (varies slightly by county).
City Transfer Tax: Certain cities (San Francisco, Los Angeles, Oakland, etc.) impose additional transfer taxes ranging from 0.45% to 6%, depending on the sale price.
Tax Calculation Example When Selling A Property
Let’s consider a hypothetical scenario:
An investor residing in California purchased a property 20 years ago for $500,000 and is now selling it for $2,000,000.
Over the years, the investor claimed $363,000 in depreciation.
The total capital gain on the sale is $1,500,000 ($2,000,000 sale price – $500,000 original purchase price).
Tax Breakdown
- Depreciation Recapture Tax: $363,000 × 25% = $90,750
- Federal Capital Gains Tax: $1,500,000 × 20% = $300,000
- Net Investment Income Tax (NIIT): $1,500,000 × 3.8% = $57,000
- California State Capital Gains Tax: $1,500,000 × 13.3% = $199,500
Total Tax Liability From Selling A Property And Not Doing A 1031 Exchange
$90,750 (Depreciation Recapture) + $300,000 (Federal Capital Gains) + $57,000 (NIIT) + $199,500 (State Capital Gains) = $647,250
This amounts to over 30% of the total sale price, significantly impacting the investor’s net proceeds.
Selling a property, especially in a state like California, typically comes with a significant tax burden, often exceeding 30% of the total sale price when factoring in federal, state, and depreciation recapture taxes. Understanding these tax implications is crucial for investors looking to maximize their after-tax profits.
However, there are strategies available to mitigate these taxes or defer them completely. One of the most popular wealth preservation strategies is the 1031 exchange.
What is the 1031 Exchange?
A “1031 exchange” is the nickname used to discuss Section 1031 of the U.S. Internal Revenue Service’s tax code. This section states that if an owner of an investment or business property replaces one investment property for another, they may be able to defer capital gains (or losses) that they would otherwise have to pay at the time of sale.
So, if the owner in the above example conducted a 1031 exchange, the owner would be able to defer all $647,250 of taxes, putting it back to work in the market and generating wealth for the exchanger. However, there are some rules an exchanger must follow in order to comply with IRS regulations and successfully defer all the taxes from the sale of the property.
Rules Of The 1031 Exchange To Defer Taxes
- Buy Replacement Property of Equal or Greater Value: To defer all capital gains taxes, the replacement property must be of equal or greater value than the net sales price of the property being sold. If an investor purchases a property of lesser value, they will be responsible for paying taxes on the difference, known as “boot.” Therefore, the exchanger in our example above would need to purchase $2,000,000 of property to defer all their taxes.
- Use A Qualified Intermediary: The IRS requires that a Qualified Intermediary (QI)—also known as an exchange facilitator—holds and transfers all funds during the exchange process. The exchanger may not receive or control the proceeds, or the exchange will be disqualified and incur a taxable event.
- Use All Sales Proceeds From The Sale To Purchase Replacement Property: To fully defer taxes, all net proceeds from the sale must be reinvested into the new property. If an investor pulls out any cash or leaves funds unallocated, that amount will be subject to capital gains tax.
- Identify the replacement property in 45 days: Investors have 45 days from the sale date to identify potential replacement properties in writing and submit the list to their Qualified Intermediary.
- Close on the property in 180 days: The exchange must be fully completed within 180 days of selling the original property. If the purchase is not finalized within this window, the exchange fails, and capital gains taxes become due.
- The replacement property must be “Like Kind.” This means the property must be held for investment or business purposes. Fortunately, the IRS defines “like-kind” broadly, allowing flexibility in asset types. So, one can sell a single-family rental and exchange it for a multifamily property, commercial asset, raw land, or a self-storage facility, just to name a few. One cannot 1031 exchange from or into a personal residence or second home.
The 1031 exchange can preserve significant wealth for real estate owners looking to sell their property in order to transition into retirement, diversify assets, respond to changing market conditions, or unlock equity built up over years of appreciation. However, one of the biggest challenges sellers face is how to reinvest their proceeds.
Many investors are not interested in locating, acquiring, and managing property from a distance. Many feel “better the devil you know than the devil you don’t.” In other words, why would you give up one source of risk and headaches for another potential risk and headaches? For these investors, many are turning to the Delaware Statutory Trust as a passive 1031 solution.
The Delaware Statutory Trust (DST): A Passive 1031 Exchange Solution
A DST is created as a trust under Delaware law, and it holds title to real estate that can be located anywhere within the United States. Investors purchase beneficial interests in the trust, similar to buying shares in a company. These investors receive potential returns per their percentage ownership from the income generated by the property as well as any potential appreciation when it sells.
Key Characteristics of a Delaware Statutory Trust (DST):
- Passive Income: Investors have no active management responsibilities; all decisions and management is made by the DST sponsor. This allows those looking to retire to spend more time doing things they like with people they love.
- Fractional Ownership: Multiple investors can own a share of a single large property or a portfolio of assets. This allows for potential diversification and access to larger properties than one may typically have access to on their own.
- Limited Liability: Investors are not personally liable for the debts or obligations of the DST. Only their principal is at risk.
- Eligibility for 1031 Exchanges: A DST interest qualifies as “like-kind” property under IRS Revenue Ruling 2004-86. This allows investors to 1031 exchange out of their property and into a fractional ownership of institutional grade real estate. Then once the property sells, they can 1031 exchange their principle and any potential appreciation into another property or DST property.
Potential Benefits of A DST
DSTs offer an attractive turn-key 1031 exchange solution for real estate investors looking to diversify their holdings, generate passive income, and reduce management burdens.
1) Turn-key 1031 Exchange Solution.
DSTs are popular among investors selling a property via a 1031 exchange because they are prepackaged for investors to sell their property and close on a DST replacement property in often 4-5 business. Typically, revenue starts immediately upon closing, and the first check is deposited the following month.
2) Built In non-recourse Financing
DSTs are often offered to investors with varying levels of debt built into the DST. So investors do not need to apply for a loan, sign for a loan, and are not personally liable for the loan. The sponsor acquires the mortgage, and the real estate is held as collateral. If the loan amortizes, investors may build up equity in the property as the principal is paid off, similar to if they owned it on their own.
3) No Management Responsibilities
DSTs are offered to exchangers with professional property management already in place. Unlike direct real estate ownership, DST investors do not have to deal with tenants, maintenance, or property management issues. The DST sponsor handles all aspects of leasing, maintenance, and operations.
4) Access to Institutional-Quality Assets
Most investors cannot afford to buy a 350-unit apartment building, a Fortune 500 Company Headquarters buildings, or Amazon distribution centers on their own. The DST allows retail investors access to the quality and scale of real estate that is typically only available to large institutions.
5) Diversification and Lower Risk
By investing in a DST, investors can spread their capital across multiple properties and markets, reducing the risk associated with single-property ownership. Instead of placing all an investor’s “eggs in one basket,” by reinvesting into a single property, investors can diversify their exchange by purchasing pieces of multiple larger properties.
So, the investor from our original example could potentially re-invest the $2M by breaking it up into 8x $250,000 investments into DSTs. This could allow the exchanger to diversify by asset type, asset class, and market. The investor would sell a single property in a single submarket, then purchase a piece of a 350 unit apartment building in Colorado, a piece of a Walmart Supercenter in Texas, a piece of a self-storage facility in North Caroline, and a piece of a medical building in Florida, etc.
6) Predictable Potential Income and Tax Benefits
DSTs typically generate potential monthly or quarterly distributions, providing investors with steady passive income per their pro-rata share of the rent. Investors are also entitled to their pro-rata share of the potential appreciation upon the sale of the property. Additionally, investors can rollover their basis from their previous property into their DST property and potentially depreciation their basis and further reduce taxable income.
Potential Drawbacks of a DST
While DSTs offer many benefits, investors should also be aware of the limitations and risks.
1) Lack of Control
Investors in a DST have no management responsibilities or decision-making authority over the property. The sponsor exclusively handles leasing, refinancing, and the eventual sale of the asset. While this means investors relinquish control, it also protects their investment from potential mismanagement, conflicting interests, or delays in critical decision-making that could result from a unanimous voting requirement that may exist in other syndications or partnerships.
2) Illiquidity
DST investments are not publicly traded, meaning investors typically cannot sell their shares easily. Most DSTs require a 5-10 year holding period before the property is sold.
3) A “Boring” Investment
The IRS imposes strict guidelines on how a DST property can be managed, limiting activities such as refinancing, lease renegotiations, capital calls, and major renovations. While some investors may view these restrictions as limiting upside potential, others appreciate the stability, transparency, and reduced risk that come with a buy-and-hold strategy. For those seeking passive income with fewer variables, the lack of complex decision-making can be a key advantage.
Getting Started With Investing In a DST Through A 1031 Exchange
RealtyMogul has built a strong reputation as a leader in real estate investing, with over $1.1 billion invested, $7 billion offered, and 290k members on the platform. Through its platform, investors gain access to high-quality, institutional-grade properties that may not be available to individual buyers.
This is particularly beneficial for 1031 exchangers who want to move from active property management to passive, professionally managed real estate assets while maintaining the tax advantages of real estate ownership.
One can use the proceeds from a property sale and invest in a DST or build a portfolio of multiple DSTs using the RealtyMogul platform. RealtyMogul provides a marketplace featuring a diverse selection of DSTs and 1031 exchange solutions, managed by third-party sponsors. Each offering is pre-vetted and underwritten before being made available on the platform.
An affiliate of RealtyMogul, RM Communities, is a sponsor that specializes in multifamily assets. The registered representative educate and advise the exchangers through the 1031 investment process and help them build a tailored solution based on their goals, objectives, and risk tolerance.
Due Diligence
RealtyMogul mitigates this risk through rigorous underwriting and due diligence via its Broker Dealer, RM Securities. Their property review process analyzes critical elements of each investment opportunity, which may include:
- Review of Real Estate Company
- Detailed Background and criminal checksReview of asset management skills and experienceReview of sponsor track recordDepth and breadth of team
- Relevant active projects and realized projects and third-party back actor checks
- Review of the Property
- Review of third-party reports, which may include environmental issues, zoning, and property condition reportsReview of historical sales values and leasing comparable
- Evaluation of the specific location, looking for an understanding of the key economic drivers and unique local market attributes
- Review of Business Plan:
- Key Business assumptionsProof of debt commitmentManagement of fees and compensation
- Planned Exit
Education
RealtyMogul believes in empowering its investors through education and transparency. RealtyMogul reps spend significant time with investors months ahead of transactions, educating the investor on the potential risk involved with each type of investment and 1031 exchanges. This process helps the investor develop their criteria and risk tolerance and equips them with the right questions to ask to perform their own research leading up to their transaction.
Top Notch Investor Services
Investor’s RealtyMogul customer service doesn’t disappear after the transaction. The RealtyMogul platform provides investors with an easy to use investor portal and investor dashboard so investors can receive updates and access their investment information 24/7. Additionally, the investors’ RealtyMogul representative is there to help with any questions or requests for tax reports or property updates pertaining to their portfolio.
Retire From Active Property Management Through A 1031 Exchange DST Investment
For real estate investors looking to retire from the burdens of active property management while preserving and growing their wealth, a 1031 exchange offers a tax-efficient way to transition into a passive investment strategy. However, the challenge often lies in finding a suitable replacement property that aligns with an investor’s goals while meeting strict IRS guidelines.
This is where Delaware Statutory Trusts (DSTs) have emerged as a powerful solution—allowing investors to exchange into institutional-grade properties, generate passive income, and enjoy the benefits of real estate ownership without the headaches of being a landlord. By leveraging a DST, investors can diversify their holdings, eliminate management responsibilities, and maintain long-term tax deferral benefits through continued 1031 exchanges.
RealtyMogul stands out as a trusted partner in this process, offering rigorous due diligence, pre-vetted investment opportunities, and a seamless transaction experience for 1031 exchangers. With access to high-quality assets, expert underwriting, and top-tier investor services, RealtyMogul provides investors with the confidence and clarity they need to make informed decisions.
If you’re considering selling your property and want to explore a 1031 exchange with a passive investment solution, partnering with RealtyMogul could be the key to achieving your financial and lifestyle goals—all while keeping more of your wealth working for you. Contact RealtyMogul today to learn how you can transition to passive income and unlock new investment opportunities.
Footnotes
1 Past performance is not indicative of future results and should not be used as a basis for an investor’s decision to invest. Investments made on the Realty Mogul platform prior to 04/17/2024 were not offered by RM Securities, LLC and should not be viewed as indicative of or attributable to any performance related to the investment products or services offered by RM Securities, LLC, nor should you assume that any products or services offered by RM Securities, LLC will in the future will be profitable or equal to any performance of cumulative or specific past investments made on the Realty Mogul platform. All information and any calculations used herein is based on information from inception through January 31, 2025 and subject to the Disclaimers and Defined Terms located on the Track Record Page.
2 Capital invested includes: (i) common equity investments in real estate companies and funds; (ii) fixed income investments including preferred equity, senior debt, and mezzanine debt in connection with the acquisition or refinance of commercial real estate; (iii) residential debt investments in connection with financing the acquisition, improvement/renovation, and sale of single family homes; and (iii) loans originated for sale which include non-fractionalized loans sold to institutional buyers. Includes capital that has been deployed by, as well as material amounts of committed but undeployed cash held by, affiliated and unaffiliated real estate companies and funds, including cash in real estate funds that has been returned from completed investments. Certain investments are made by Realty Mogul, Co. or its affiliates. This information should not be used as a basis for an investor’s decision to invest. Investment opportunities on the RealtyMogul Platform are speculative and involve substantial risk.
Disclosures
Financial Samurai may receive compensation for providing the information on this page. Not a recommendation to buy or sell securities. Investing includes the risk of loss. Securities are offered by RM Securities. See full Disclosures on www.realtymogul.com.
*Investment involves risk. See the link for Risk Disclosure.
Brokerage services are offered by RM Securities, LLC, an SEC-registered broker-dealer (member FINRA/SIPC). Research RM Securities, LLC, on FINRA’s BrokerCheck. Brokerage services are not intended for or directed to, nor will they be provided to, residents in any other state or otherwise where the provision of such services would violate any state law.
1031 Exchange Risk
Internal Revenue Code Section 1031 (“Section 1031”) contains complex tax concepts, and certain tax consequences may vary depending on the individual circumstances of each investor. RM Securities and its affiliates make no representation or warranty of any kind with respect to the tax consequences of your investment or that the IRS will not challenge any such treatment. You should consult with and rely on your own tax advisor about the tax aspects with respect to your particular circumstances. Please note that RealtyMogul does not provide tax advice.