Austin Bowlin, a CPA and partner at Real Estate Transition Solutions, is finding this out among his investor clients.

“It’s becoming more time-consuming for them and, frankly, riskier because if they have a bad tenant, it can be difficult to process evictions and collections can be troublesome,” he told Business Insider. “And these properties require regular capital expenditures and upkeep. They’d rather have something that is more passive.”

Selling the property isn’t a very attractive option, he pointed out.

For starters, his clients recognize the value of having real estate make up a portion of their portfolio: “They like it as an asset class. It’s done well for them. But they’re not really interested in continuing to manage property.”

Plus, they’d pay significant taxes on the sale of the investment property. In states like California, the total tax can be as high as 42%.

There happens to be a little-known solution for investors who want to eliminate active management and defer capital gains tax.

How a 1031 DST Exchange works

There are two important concepts to understand that are wrapped up in this tax strategy: a 1031 exchange and investing in a Delaware Statutory Trust (DST).

A 1031 exchange allows an investor to sell a property without paying capital-gains taxes on the sale, as long as they replace it with another property of equal or greater value. As the name suggests, you’re exchanging one property for another and, in the process, avoiding capital-gains taxes that can be significant.

Bowlin, whose firm specializes in tax-deferred 1031 exchange strategies, gives an example: Say a California-based couple purchased a 10-unit apartment building in 1990 for $1 million.

“Let’s say it’s now worth $3 million,” he explained. “If they sold that property for $3 million in 2024 they’d be walking away having paid about $1.2 million in tax.”

Of course, California has the highest state income tax in the country. But even if that couple lived in a different state, there’s still a major tax consequence, he pointed out: “If you sell a property in Texas or Florida or Washington or Nevada, where there is no state income tax, then your tax liability is lower, but it’s still significant. That $3 million sales price in Washington would probably translate to somewhere around $800,000 in taxes.”

That’s why a 1031 exchange can be so advantageous, as you can defer your tax liability.

“But a 1031 exchange in and of itself isn’t the sole answer because now they have to figure out, ‘What would I exchange into?'” said Bowlin. If they buy another investment property, they’re back where they started: actively managing a different property.

This is where DSTs come into play. As a DST investor, you essentially own a fraction of the investment property owned by the trust (which are typically high-grade institutional properties). And, thanks to a 2004 ruling by the IRS, DSTs are 1031 exchange eligible.

That means you can sell a property, take the funds from the sale, and perform a 1031 exchange into owning a portion of large, institutional properties and start generating passive returns.

For example, one of Bowlin’s clients is taking $2.1 million worth of proceeds and exchanging it into various types of properties, from a senior housing property in Texas to a portfolio of 22 industrial properties around the Midwest and Midatlantic.

“He’ll now have exposure to — direct ownership of, in the eyes of the IRS — right around $600 million of real estate that his $2 million will be invested in, and it’ll be entirely passive for him,” said Bowlin. “In the first year, he’ll generate about $111,000 in cash flow. And so he’s going to be diversified, not have any management responsibility, have full tax deferral into these properties, and then, eventually, when these properties sell, he can do another 1031 exchange. Then, if he or his wife ever passes away, all that deferred tax liability will be eliminated, and the surviving spouse can just take the sales proceeds with little to no tax consequences.”

Note that this option is only available to accredited investors, which is typically defined as having a net worth over $1 million not including the value of your primary residence, or an annual income of $200,000 as an individual ($300,000 if you’re married, filing jointly).

“About four years ago, the SEC expanded the definition to include people that hold CFA charters or securities licenses,” noted Bowlin.

He added that exchanging into DSTs is not without risk.

“It’s direct investment in the real estate. Even though you don’t own the entire property, you own a portion of it,” said Bowlin.

That said, “most of those risks are what the owners are accustomed to, having owned and managed investment real estate. And one could make a strong case that they’re actually lowering the risk profile by diversifying among different property types and different geographic markets.”

While this strategy is becoming increasingly popular, thanks to its many advantages, “the biggest issue we deal with is just awareness,” said Bowlin. “Most people don’t even know it’s an option.”