A millennial traded in his rental for fractional shares of commercial buildings using a little-known strategy. He now yields $550 a month and doesn't deal with landlord headaches.

• Jose Palafox sold his Portland rental and invested in a Delaware Statutory Trust (DST).
• DST 1031 exchanges allow investors to defer capital gains taxes on the sale of a property
• DSTs provide fractional ownership in institutional properties, reducing landlord responsibilities.

After years of owning a rental unit in Portland, Jose Palafox was ready to sell.

"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 with a rental in the first place when he moved from Portland to the Bay Area in 2014. Rather than sell his Portland condo, which he bought as a primary residence in 2011, he decided to fill it with a tenant.

Around the same time Palafox started readying the property to sell in June 2024, he heard about "like-kind exchanges" from a family member. Also known as a 1031 exchange, this is a tax-deferred transaction that allows an investor to sell a property without paying capital-gains taxes on the sale if they replace it with another property of equal or greater value.

Deferring his tax liability was intriguing but, ultimately, he was worried about meeting the strict exchange deadline: As soon as you sell your property, you must identify your replacement in writing within 45 days of selling the first property. Then, you must close on the replacement property within 180 days of your initial property sale.

Plus, if he exchanged into another investment property, he'd find himself back where he started: as a landlord, managing a different rental.

While researching 1031 exchanges, he came across a variation of the strategy known as a DST 1031 exchange, which would allow him to defer capital gains tax and eliminate active management.

When you buy into a Delaware Statutory Trust, or DST, you own fractions of the investment properties 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.

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 or $300,000 if you're married and filing jointly. (Palafox met the income criteria.) Your property doesn't have to be fully paid off — Palafox had paid down about half of his mortgage when he decided to exchange into a DST — but you have to maintain or increase your leverage.

In addition to avoiding capital-gains taxes, Palafox saw other major advantages to exchanging into a DST, which he did in the summer of 2024, according to an exchange statement viewed by BI.

1. Low investment minimum and no loan responsibility. In the real estate investing world, Palafox wouldn't be working with that much capital after selling his condo, he noted: "There isn't much or any investment grade property I felt I could buy with $130,000. The DST product I picked has a $100,000 minimum, so I was able to purchase with the proceeds of my sale without having to bring in any extra capital to the table."

He'd also be able to avoid taking a loan, which wouldn't necessarily be possible if he did a traditional 1031 exchange.

"In order to 1031, you have to maintain your leverage or debt in the subsequent purchase," he explained. "So, I would have had to take a loan, which is an arduous process made even harder with high rates and my general lack of real estate investing experience. With the DST, the financing is part of the product; the specific DST product I purchased matched my leverage in my existing property."

2. Hands-off ownership. By investing in a DST rather than a physical property, Palafox could have real estate in his portfolio without having to find tenants, manage maintenance requests, or deal with the many tasks that come with being a landlord.

He could also skip the process of actually finding a property, which entails driving through neighborhoods, attending open houses, inspecting prospective properties, and making offers.

"This DST product was 'on the shelf,' so to speak, so once we picked the right product there were no other significant purchasing hurdles," he said.

3. Access to stable, investment-grade properties. "I was able to get fractional ownership of a diverse range of properties already under professional management with predictable projected cash flows," said Palafox, whose DST includes commercial properties that would have been too expensive for him to purchase as an individual investor.

4. The 'UPREIT' option. Palafox said that what really sold him on moving forward with the DST 1031 exchange 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.

Executing the DST 1031 Exchange: A lot of paperwork and moving parts

The first step Palafox took was meeting with a financial advisor to understand his many options.

"If you're looking at doing a DST, your most important player is your financial advisor, as they know the end-to-end process and will be your main point of contact through the process," he said.

There are several DST sponsors to choose from, each with many different offerings, from Amazon warehouses to multi-family properties to commercial buildings, and his advisor helped him sift through the options and ultimately settle on one.

In Palafox's experience, there was a lot of paperwork and 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 (who he was buying from).

He also had to find a qualified intermediary (QI). A QI is a neutral third party that holds the home sale proceeds until the investor buys their replacement property, which was the most unsettling part of the process for Palafox.

"For a period of time it felt like I had no idea where my money was from the sale of my apartment," 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."

The aftermath: $550 a month landing in his checking account

Palafox says that he's earning more in dividends than he was renting his condo: "I am yielding over $500 a month direct deposit to my checking account, some of it tax-free due to depreciation, and I don't have to find tenants or deal with maintenance, and my credit looks better with the debt off books."

BI looked at a $549 deposit made into his checking account from the DST.

Exchanging into DSTs is not without risk. You're investing in real estate, and even though you don't own properties outright, you own a fraction. That said, if you're considering a DST exchange in the first place, you're accustomed to the risks that come with real estate, and one CPA told BI that, "One could make a strong case that they're actually lowering the risk profile by diversifying among different property types and different geographic markets."

ZPalafox expects tax season to be more complex than usual.

Depending on the DST product you own, "you could be paying taxes in multiple additional states," he said. "I will use an accountant but I expect some increased costs and complications to file come tax time."

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.

Now that he's receiving monthly deposits, Palafox says he feels more confident in his investment — and keeping tabs on the properties in his DST gives him peace of mind: "Occasionally I zoom in on the buildings on Google Maps and make sure they are still there."