- Jose Palafox used a DST 1031 exchange to defer taxes on his Portland rental sale.
- The strategy allows reinvestment into a trust, so Palafox no longer has to manage a property.
- It wasn’t the simplest strategy to execute and involved a lot of paperwork and moving parts.
In the summer of 2024, Jose Palafox took advantage of a little-known tax strategy called a DST 1031 exchange, which allows investors to avoid capital gains tax on the sale of a rental property.
Palafox was ready to sell his Portland rental, which had become more of a headache than a cash cow.
“My HOA fees had increased, my taxes had increased, and rents in Portland had gone down, so I wasn’t making much if anything,” the San Francisco-based millennial told Business Insider. “And I hadn’t ever wanted to be a landlord.”
He found himself a landlord when he got a job offer in the Bay Area while living in Portland. Rather than selling his primary residence at the time, he converted it to a rental, heeding common advice to hold onto real estate: “Everyone told me, ‘Buy a house and don’t sell it.'”
Executing a DST 1031 exchange, in which you sell a property and reinvest the proceeds into a Delaware Statutory Trust (DST), not only allowed him to defer capital gains tax — it also released him from landlord responsibilities. He essentially exchanged his Portland condo for a DST, which holds commercial real estate assets, and now owns fractions of high-grade institutional properties. He receives a $550 dividend payment each month, which BI verified by looking at a deposit made into his checking account from the DST.
Palafox says he’s bringing in more from the DST than he was when he was renting his condo, and the investment is completely passive.
It was the right move for him and his financial situation — he didn’t need to touch the proceeds from the property sale and could afford to reinvest it — and he avoided a tax consequence while gaining exposure to real estate assets he could never have afforded as an individual investor.
Of course, the process, which Palafox completed in the summer of 2024 according to an exchange statement viewed by BI, didn’t come without its barriers to entry. Here are the challenges he faced before and during the exchange.
1. You have to be an accredited investor. To do a DST 1031 exchange, you have to be what’s called an accredited investor. There are a few ways to qualify: having a net worth over $1 million, not including the value of your primary residence; having an annual income of $200,000 as an individual or $300,000 if you’re married and filing jointly (this is how Palafox qualified); or having certain professional certifications, such as the Series 7, Series 65, or Series 82 licenses.
Unless you’re an accredited investor, it can be difficult to even find information about various DST sponsors, noted Palfox, who hired a financial advisor to walk him through his options: “You have to be a qualified investor in order to even see the list of available DSTs.”
2. Prepare to deal with a lot of paperwork and multiple parties. In Palafox’s experience, there was a lot of paperwork — he said he signed about 10 documents via Docusign from start to finish — and there were a lot of moving parts. In addition to his advisor, he worked with a real-estate agent to list and sell his rental, two separate title companies (one for the property sale and another for the DST), and the DST sponsor.
He also had to find a qualified intermediary (QI). This is a neutral third party that holds the home sale proceeds until the investor buys their replacement property.
3. It can be an emotional roller coaster, especially when your money is with the QI. The most unsettling part of the process for Palafox was immediately after he sold his rental.
“For a period of time it felt like I had no idea where my money was from the sale,” he said. On paper, his six-figure sale proceeds were in an escrow account, “but beyond a piece of paper I docusigned and the general say-so of people I’d never met on email I didn’t really know how I would get my money back if I had to. My wife accused me of getting into a Ponzi scheme for a while.”
He still has some anxiety about his investment because it’s so different from anything else he owns. The only “proof” he has that he owns anything is an email from his DST sponsor congratulating him for his purchase, “which is still kind of terrifying,” he said.
4. It could complicate your tax situation. “One thing I am not looking forward to is paying taxes,” said Palafox. “Depending on the product you could be paying taxes in multiple additional states. I will use an accountant but I expect some increased costs and complications to file come tax time.”
Even once you’ve gotten past the major barriers to entry to doing a DST 1031 exchange, “it’s still a lot more challenging and in some ways less satisfying than clicking a button on your favorite trading app and buying stocks or crypto,” he added. “There’s no ticker to watch, these are boring investments that produce boring returns.”
Still, he’d deal with the paperwork and stress all over again if he could go back, particularly because of the “UPREIT” option. Palafox said that what really sold him on this strategy was another tax code “loophole,” of sorts, known as the 721 exchange, or UPREIT.
Eventually, a DST will end (most have a predetermined lifespan of five to 10 years), at which point his options are “to either 1031 into another DST or, ideally, be bought by a REIT fund that wants to own and operate these buildings longer term,” he said. “Using a 721 exchange, I can roll into the REIT fund, again deferring taxes. At the end of this process, I would own shares in a private or public REIT, which I could fractionally liquidate. So, if I want to sell half of my investment, I could.”
In short, at the end of his DST, he could get into a REIT without causing a taxable event.
“When I finally understood the flow from my investment into a REIT fund, the light really went off for me,” he said. “I remember saying, ‘Wow, this is the future,’ and now I’m a bit of a fan, I guess.”
Source link
lol
