California taxes real estate gains at up to 13.3%, stacked on federal capital gains and depreciation recapture. On Maria's sale, that combined bill came to about $185,000. A 1031 exchange into Delaware Statutory Trusts let her defer all of it and stay invested through professionally managed property.
This case study is illustrative. Names, figures, and details are composite examples based on common investor scenarios. Consult a qualified tax professional for advice specific to your situation.
A $125,000 house that became a $185,000 tax problem
Maria bought a single-family home in San Francisco's Sunset District in 1995 for $125,000. It was an ordinary rental in an ordinary neighborhood, bought before the boom, when Bay Area prices still looked reasonable.
She held it for 27 years, collecting rent, screening tenants, coordinating repairs, and filing returns. Over those three decades San Francisco real estate ran away from the rest of the country. By 2022, when she decided to sell, the house was worth about $515,000.
On paper she was wealthy. In practice, selling meant handing a large slice of that gain to the government.
What California does to a real estate gain
After the sale closed in late 2022, Maria's accountant added up the bill.
The gain itself was simple arithmetic: a $515,000 sale price against a $125,000 purchase price, a capital gain of $390,000. But there was a second layer. Over 27 years Maria had claimed depreciation on the building, the yearly deduction that treats a rental as slowly wearing out. Selling reverses that benefit through depreciation recapture, roughly $98,000 here under Section 1250. Recapture lowered her adjusted cost basis from $125,000 to about $27,000, which lifted her total realized gain to roughly $488,000.
The federal tax came in three pieces:
- Long-term capital gains tax at 20% on the $390,000 of appreciation: about $78,000
- Depreciation recapture tax at 25% on the roughly $98,000 of past deductions: about $24,500
- Net Investment Income Tax at 3.8%, a surtax that applies above $200,000 of income for singles and $250,000 for couples: about $18,500
That is roughly $121,000 to the IRS.
California adds its own layer, and it makes no distinction between capital gains and ordinary income. The state taxed the full $488,000 gain at 13.3%: about $64,900.
Add it up and the bill comes to about $185,900, call it $185,000, roughly 35% of her gross sale proceeds. Sell, pay, and Maria keeps around $335,000 of her $515,000. For a gain she spent 27 years building, that was a lot to hand over at once.
The 1031 exchange, in one sentence
Maria's advisor walked her through a 1031 exchange: sell an investment property, roll the entire proceeds into another qualifying property within a strict timeline, and defer the capital gains and recapture tax instead of paying it now.
Deferred tax is not forgiven tax. But money that stays invested keeps working. As an illustration: take roughly $180,000 of the deferred bill, leave it invested at a hypothetical 5% a year, and in a decade it would grow to about $293,000, roughly $113,000 more than the starting figure. That difference comes from postponing the tax rather than paying it up front.
Maria decided to pursue the exchange.
Selling first, then the clock
Maria's house closed on November 30, 2022. About $515,000 in net proceeds, after commission and closing costs, went not to her but to a qualified intermediary: a third party who holds the money so the seller never takes possession, which the rules require.
From that closing date, two clocks started. She had 45 days, until January 14, 2023, to identify her replacement property in writing, and 180 days to close on it.
She didn't want another San Francisco rental. The management, the local rules, the running costs - after 27 years, all of it felt like too much. She wanted to stay in real estate but hand off the work, so she looked at Delaware Statutory Trusts, or DSTs: trusts that let many investors co-own large, professionally managed properties through fractional beneficial interests, and whose interests qualify as replacement property for a 1031 exchange.
Her aim was two properties: one multifamily building for steady distributions, and something in a different sector or region to diversify away from a single San Francisco house.
The two replacement properties
By mid-December her advisor had several DST offerings on the table. Maria chose two.
Phoenix multifamily. $290,000 into a 157-unit apartment complex, a 1.85% beneficial interest. The sponsor, an established operator with more than 15 years of track record, projected a 4.25% annual distribution, about $12,325 a year or $1,027 a month, over a 7-year hold.
Austin medical office. $225,000 into a 68,000-square-foot, single-tenant, physician-owned building, a 2.1% beneficial interest. The sponsor, a healthcare real estate specialist, projected a 4% annual distribution, about $9,000 a year or $750 a month, over an 8-to-10-year hold.
Together: $515,000 deployed, and projected distributions of $21,325 a year, about $1,777 a month, as estimated by the sponsors. Both properties sat in lower-cost markets priced at higher yields than comparable California real estate, and both were run by professional managers, which was the whole point.
She submitted her written identification to the intermediary on January 10, 2023, well inside the 45-day window.
Closing within 180 days
A DST closes when its sponsor finishes raising capital and acquires the building, so the two ran on slightly different schedules:
- January 30, 2023: the Phoenix DST closes, and Maria's $290,000 buys her 1.85% interest in the apartment complex.
- February 14, 2023: the Austin DST closes, and her $225,000 buys her 2.1% interest in the medical office.
Both closed well within 180 days of her November 30 sale, so the exchange held. By late February 2023 Maria owned no California real estate and held interests in two out-of-state, professionally managed properties that required nothing from her.
The tax bill, deferred in full
Maria's 2022 return, filed in spring 2023, reported the exchange on Form 8824. The $390,000 capital gain was realized, but the federal tax, the state tax, and the depreciation recapture on it all came to zero for the year. The roughly $185,000 that would otherwise have been due was deferred, and it stays deferred as long as she holds the DST interests.
The income, without the phone calls
Her first distribution arrived in March 2023, about three months after the sale closed: $1,027 from Phoenix. Austin followed the next month. By April both were paying monthly, $1,027 and $750, $1,777 together, deposited electronically and on schedule.
Her old rental had produced roughly $1,800 a month after expenses, though that number moved with vacancies and the occasional surprise repair. The DSTs projected $1,777. About the same cash, with one difference: the old building came with tenants and maintenance; the new interests came with neither.
Depreciation that follows her into the DST
Every February, each DST sends Maria a K-1 showing her share of the property's income and deductions. The depreciation passes through to her return: $7,650 from Phoenix, $5,220 from Austin, $12,870 in all.
That shelters most of the cash she receives. On $21,325 of distributions, only about $8,455 was taxable ($21,325 minus $12,870). At a 24% federal marginal rate that is about $2,029, plus $1,125 in California tax, for roughly $3,154 on the year.
Held directly, the old rental's income would have been fully taxable: 24% federal on $21,600 is $5,184, plus $2,873 to California, about $8,057. So the pass-through saved her roughly $4,900 in the first year, on top of the deferral, and it repeats each year she holds.
Why not exchange into another California building
Asked why she left the state's real estate entirely, Maria gave three reasons.
The market. San Francisco's rules - rent control, strong tenant protections, long eviction timelines - make hands-on management hard.
The yield. Cap rates, a property's annual income measured against its price, run lower in California. A $515,000 Bay Area property might throw off $28,000-$32,000 in rent a year, roughly 5.4%-6.2% of its price; the same money in Texas or Arizona might produce $35,000-$40,000, roughly 6.8%-7.8%.
The stage of life. Approaching 60, Maria wanted less to manage, not more. Direct ownership, even nearby, meant staying on call. The DSTs took the work off her plate while putting her money into higher-yielding markets.
What happens to the deferred gain at death
Maria's DSTs were structured with her estate in mind. Under current rules, when she dies her heirs inherit the interests at their fair market value on that date, a stepped-up basis. The built-up gain, the roughly $390,000 that was deferred rather than paid, is wiped out for tax purposes. Her heirs would inherit about $515,000 of real estate interests, plus any later appreciation, with no capital gains liability on the years Maria held them.
That is the far end of the strategy: deferral during life, and, under current law, elimination of the deferred gain at death. How it applies to any particular estate is a question for a tax professional.
Three years in
By 2026, three years into the exchange, Maria has collected roughly $54,000 in distributions. At a modest 3% a year, her interests might be worth about $563,000, up from $515,000. The roughly $185,000 in tax she deferred is still hers and still invested. Against the alternative of selling, paying that bill, and reinvesting what was left, keeping the whole sum at work has, in this illustration, left her on the order of $100,000 ahead over time.
What Maria's story shows
Two things did the heavy lifting. The first is the size of California's bill: 13.3% at the state level, stacked on federal capital gains and recapture, is why deferral figures so prominently in the state's real estate planning. The second is the structure. In Maria's case a single DST exchange deferred the tax, handed off the management, spread her money across two markets and property types, and added a depreciation shelter that trimmed her yearly tax, all at once.
The details carry their own lessons. She had 45 days to identify and 180 to close, and she used the time rather than rushing it. The K-1 depreciation is what keeps DST income tax-efficient year to year. And the stepped-up basis is why the approach is so often paired with estate planning: what deferral postpones during life, current law can erase at death.
None of that removes the tradeoffs. Deferred tax is still owed if the chain of exchanges ever breaks, and the distributions are projections, not guarantees. But for an investor sitting on a large, appreciated California gain, Maria's story shows why the exchange draws so much attention. The deferral is the mechanism; the time it buys is the point.
Maria's story shows how a 1031 exchange works when the tax bill is large: rather than pay about $185,000, she deferred it and kept the whole sum invested. The bigger the combined state and federal bill, the more a deferral keeps invested rather than paid out, which is why the strategy draws so much attention from investors sitting on appreciated California property. Whether it fits any particular situation is a question for a tax professional.
Frequently asked questions
How much did Maria actually defer in taxes?
Her total realized gain was about $488,000: a $390,000 long-term capital gain plus roughly $98,000 of depreciation recapture. Federal capital gains tax at 20% on the $390,000 was about $78,000, recapture tax at 25% on the $98,000 was about $24,500, and the 3.8% Net Investment Income Tax added about $18,500. California taxed the full $488,000 at 13.3%, about $64,900. The total deferred was about $185,900, or roughly $185,000.
What was Maria's original property purchase price and details?
She bought a single-family home in San Francisco for $125,000 in 1995 and rented it out for 27 years, by which point it was worth about $515,000. Over those years she claimed roughly $98,000 in depreciation, which is what created the depreciation recapture tax when she sold.
Why did Maria choose DSTs instead of buying another California property directly?
She wanted out of California landlording without giving up the tax deferral. A San Francisco rental meant rent-controlled tenants, layered local rules, and high running costs. DSTs offered professional management, geographic diversification, and passive income, so she chose simplicity over direct ownership.
How are Maria's DST distributions taxed?
Each DST sends her a K-1 reporting her share of income, depreciation, and any principal repayment. The depreciation passes through to her return and offsets much of the distribution income, so her tax bill on DST income is lower than the tax on the same amount of rental income would have been.
Did Maria use the full exchange timeline?
Yes. She identified her two DSTs on January 10, 2023, within the 45-day window, and both closed within the 180-day window. She used most of the time available rather than rushing the decision.