California is home to one of the most active and complex real estate markets in the country. The state is wealthy, with diverse markets that range from high-value properties to areas with promising growth potential. As you set your eyes on this location, however, it’s important to consider California’s unique characteristics and potential challenges. From high acquisition costs to the complex tax landscape, there are many variables investors must take into account.
One possible investment option for entry into California markets is joining a Delaware Statutory Trust (DST). If you combine this strategy with a 1031 exchange, you may be able to obtain federal tax-deferral benefits as well as hands-off day-to-day operations involvement. In this article, Realized 1031 offers a guide about DST investments in California — how they work, specific considerations for the state, as well as the pros and cons. Keep reading to learn more.
Delaware Statutory Trusts (DSTs) are commonly used nationwide, including in California, as a vehicle for fractional real estate ownership. The framework is based on the Delaware Statutory Trust Act of 2002, which created a standardized structure recognized nationwide for facilitating such co-ownership arrangements, including those within California.
While the legal structure is standardized, investors in California should be aware of state-specific tax considerations, such as withholding rules, nonconformity with federal §1031 treatment, and property tax reassessment risks under Proposition 13.
Key characteristics of a DST include the following.
DSTs are often used as replacement property in §1031 exchanges, offering an option for investors seeking passive ownership while deferring capital gains taxes—provided IRS rules and timelines are followed.
While §1031 exchanges are governed by federal tax law, California applies state-specific tax and regulatory rules that can affect investors differently than in other jurisdictions. When structured properly, investors may benefit from tax deferral benefits. Here are some of the Federal rules for 1031 exchanges.
One of the key rules in a §1031 exchange is the like-kind requirement, which mandates that both the relinquished and replacement properties must be held for investment or productive use in a trade or business. While DST interests are considered securities under federal law, the IRS addressed their eligibility in Revenue Ruling 2004-86. This ruling clarified that, under certain conditions, a beneficial interest in a Delaware Statutory Trust may be treated as an interest in real property for the purposes of a §1031 exchange.
As a result, many investors use DSTs as a form of replacement property in §1031 exchanges. This structure may provide access to institutional-grade real estate and allow for fractional ownership in one or more properties—subject to IRS rules, offering availability, and investment suitability.
Here are some special considerations to keep in mind as you enter a DST based in California.
Apart from federal-level tax filing requirements, nonresidents and residents alike must file income earned at the state level. The California Franchise Tax Board (FTB) will require you to report your income even if you’re not a resident of the state — as long as you own property in it. Form 540 and Form 540NR are the documents you need to fill out and submit.
California’s Proposition 13 sets the property tax at 1% of the market value at purchase or new construction. However, a change in ownership — such as a property sale within a DST — can trigger reassessment at current market value, raising taxes. This potential increase is important to consider when evaluating California-based DSTs, as it may impact overall investment returns.
You may also face withholding requirements if you’re a non-resident property seller or if you’re collecting rental income. Nonresident sellers of California real estate are generally subject to withholding of 3.33% of the total sales price or 12.3% of the recognized gain, reported on Form 593. Non-resident investors can use the withheld amount as a credit against their state income tax when filing, which may lower their final tax bill.
On a federal level, the Securities and Exchange Commission regulates DSTs. On the state level, the regulating entity is the California Department of Financial Protection and Innovation. You may need to comply with the requirements set by the department to avoid any issues or penalties.
One more specific consideration to keep in mind for California DSTs is the importance of working with tax and legal professionals who are familiar with state laws and processes. While all states have their own taxation environment, California is on another level. Engaging qualified advisors helps ensure compliance with applicable regulations, supports sound decision-making, and may reduce the risk of unexpected tax liabilities.
Investors in California will find DSTs beneficial because, aside from the tax deferral benefits of 1031 exchanges, there are some other specific advantages you can expect:
Under §1031 of the Internal Revenue Code, investors who sell real property held for investment or business use may defer recognition of capital gains by reinvesting proceeds into like-kind property. A properly structured DST may qualify as such a replacement property if all IRS requirements are met.
This tax advantage also offers relief, given how California will still require you to pay capital gains taxes at the federal level. The highest rate is 13.3% in the state. While state tax cannot be deferred in all cases, the federal deferral available through §1031 may help investors retain more capital for reinvestment.
Compared to most other states in the U.S., California has one of the most diverse and dynamic economies. Because DST minimum investment thresholds are typically lower than the cost of acquiring whole properties, investors may also be able to distribute proceeds across multiple DSTs, subject to availability and offering terms.
DSTs are structured to be passive investments. All operational decisions—including property management, leasing, and capital expenditures—are handled by the DST sponsor or trustee. For investors seeking to step away from active property ownership, this may offer a lower-maintenance alternative to direct ownership. California DSTs are often offered by experienced sponsors familiar with complex markets and regulatory environments. Even so, investors are encouraged to carefully evaluate sponsor qualifications, track records, and disclosures provided in the Private Placement Memorandum (PPM).
There are inherent risks that investors should consider to mitigate their impact.
One challenge with DSTs is how they can have long holding periods, ranging from 5 to 10 years. Within this timeframe, your funds are essentially locked up. If you foresee the need for liquid cash in the near future, then DSTs may not be the best choice. Plus, finding a secondary market where you can sell your beneficial interest before the property is sold can be difficult and is not guaranteed, adding to the illiquidity.
While the hands-off involvement can be an advantage to some investors, this may not be ideal for those who still want some level of control over the asset. This lack of control may be a disadvantage for those who prefer a more active role, especially in markets like California where local conditions can shift quickly.
Like any other type of investment, DSTs are still vulnerable to market risks. Inflation, decreased demand in the region, and natural disasters can affect the profitability of the asset. There’s also the fact that the property values in California are subject to cyclical performance, regulatory changes, and external pressures such as inflation or natural disasters.
One more major consideration for DST investments is the complex tax landscape of California. The rules we mentioned above, such as Provision 13 and state tax requirements, are just some of the various things you’ll have to comply with. There’s also the state’s clawback rule, which may subject former residents to California capital gains taxes on prior California-sourced property sales, even after relocating out of state.
Before entering the California market through a DST, it’s important to conduct your due diligence on the offerings you’ve identified. Make sure to check the private placement memorandum thoroughly and assess factors such as the following.
Aside from due diligence, understanding California tax rules is also essential. The best practice is to engage with experts like us at Realized 1031. We can provide guidance and resources that help you navigate this complex landscape.
Finally, don’t be afraid to ask questions. Don’t hesitate to ask the sponsor or your financial advisor detailed questions about any aspect of the DST offering that you don’t fully understand. Even investors with sophisticated knowledge of the market will still find themselves lost in certain scenarios, so being open to asking questions is important to ensuring that you’re fully informed before making a major investment decision.
Entering a DST in California through a 1031 exchange may offer qualifying investors a way to defer capital gains taxes and access professionally managed real estate in California’s dynamic property markets. However, navigating the state’s complex tax environment requires careful planning and professional guidance. By staying informed and working with experienced advisors, you can make strategic, compliant decisions that support long-term investment goals in the California real estate market.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Article written by: Story Amplify. Story Amplify is a marketing agency that offers services such as copywriting across industries, including financial services, real estate investment services, and miscellaneous small businesses.
Sources:
https://smartasset.com/investing/delaware-statutory-trusts-dsts
https://www.investopedia.com/financial-edge/0110/10-things-to-know-about-1031-exchanges.aspx
https://www.irs.gov/pub/irs-drop/rr-04-86.pdf
https://assessor.lacounty.gov/real-estate-toolkit/proposition-13
https://smartasset.com/investing/california-capital-gains-tax
https://www.ppic.org/publication/californias-housing-market/