DST vs Paying the Capital Gains Tax: When Is the 1031 DST Route Worth It?

The check you would write has four layers, and recapture is the one sellers forget

The federal long-term rate is 0%, 15% or 20% depending on taxable income, and Rev. Proc. 2025-32 sets the 2026 breakpoints at $98,900 and $613,700 for joint filers ($49,450 and $545,500 for single filers). The gain itself counts toward taxable income, so a large sale pushes most of itself into the 15% or 20% band even for a retiree with modest pension income.

Depreciation you claimed comes back first: IRS Topic 409 taxes unrecaptured §1250 gain at a maximum 25%. On top of both, Topic 559 adds the 3.8% net investment income tax once modified AGI passes $250,000 joint or $200,000 single, thresholds that are not indexed for inflation.

The state layer swings the answer more than any other. California states that it 'does not have a lower rate for capital gains' and taxes them as ordinary income, with a top rate of 13.3% per the Tax Foundation's 2025 table, while Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas and Wyoming levy no individual income tax at all (rules by state).

• Hypothetical A, $500,000 gain (joint filers, $100,000 of it prior depreciation): 25% × $100,000 = $25,000; 15% × $400,000 = $60,000; 3.8% × $500,000 = $19,000. Federal total $104,000. Texas total $104,000 (21% of gain); California up to $170,500 (34%).
• Hypothetical B, $2,000,000 gain ($400,000 of it prior depreciation): 25% × $400,000 = $100,000; 20% × $1,600,000 = $320,000; 3.8% × $2,000,000 = $76,000. Federal total $496,000. Texas total $496,000 (25%); California up to $762,000 (38%).
• State figures use the top marginal rate as a ceiling; your actual state bill depends on brackets, so have your CPA run the real number.

Compare working dollars, not tax saved: the load comes off the top of a DST

The honest comparison is how much real estate each route leaves working for you. A DST's offering costs are paid from your equity before a dollar reaches the property; David Silverman's 2024 DST outline puts up-front fees at 'between 10 to 18 percent of the equity invested,' and the Form D for ERP 1031 Industrial Portfolio IV DST filed in January 2026 budgeted $3,253,500 of commissions on $36,150,000, or 9.0%, before other organizational costs and reserves (what the load contains).

Take hypothetical A as a $1,500,000 debt-free sale with a $1,000,000 adjusted basis and a 10% load. Paying the tax in Texas leaves $1,396,000 to reinvest with a fresh basis; the DST route puts $1,500,000 in but only about $1,350,000 reaches property and reserves. Paying wins on working dollars, and the DST must justify itself on deferral compounding, passivity or the step-up alone.

Take hypothetical B as a $3,000,000 debt-free sale with a $1,000,000 basis. Paying the tax leaves $2,504,000 in Texas or $2,238,000 in California; the DST route leaves roughly $2,700,000 working after a 10% load, a gap of $196,000 to $462,000 that the deferral route starts with on day one.

Fees, illiquidity and modest yields erode the deferral, so price them in

Deferral is an interest-free loan from the Treasury, but a DST charges admission for it and then locks the door: there is no organized secondary market and you wait for the sponsor's sale (how hard early exits are). One broker's published range for its active income DSTs in early 2026 was 4.0% to 8.0% cash-on-cash after expenses (Baker 1031), and sponsors disclose that distributions 'are not guaranteed and may be sourced from non-income items and constitute a return of capital' (NexPoint's DST disclosure).

Put the load against the deferred tax. In hypothetical B, $762,000 of California tax stays invested; at a hypothetical 5% distribution that is about $38,000 a year of income the pay-now investor never sees, so seven years recovers roughly $270,000 before tax, on top of the $300,000 load being spread over a $3,000,000 base. In hypothetical A in Texas, $104,000 deferred at 5% is $5,200 a year, which never catches a $150,000 load.

Sponsor and leverage risk belong in the same ledger. Trusts with loans placed at 2020-2021 rates have faced refinancing realities their projections did not model, and a handful of sponsors have had financial trouble, as Kiplinger reported in June 2026; read the loan maturity and the reserve before the yield (DST leverage risk).

Horizon and age: deferral compounds every year and ends cleanly only at death

The deferred tax never goes away on its own; each DST sale either triggers it or requires another exchange within 45 and 180 days (the next 1031 after a DST sells). A 45-year-old who expects to cash out in eight years is borrowing the tax, not avoiding it, and should value the DST route mainly on the compounding and on shedding management.

A 75-year-old is in a different calculation. §1014(a)(1) resets an heir's basis to fair market value at death, which wipes out the deferred gain and the accumulated depreciation together, and the 2026 basic exclusion of $15,000,000 means most estates owe no estate tax on the way through (DSTs in estate planning and swap-till-you-drop planning).

Between those ages the question is whether you would rather hold real estate you cannot touch for the sponsor's hold or cash you have already been taxed on. The DST's cash-flow projections do not decide that; your spending plan does.

When writing the check to the IRS is the better move

Paying the tax is often right, and a broker who never says so is not being straight with you. It is right when the tax is small relative to the load, when the money has a job to do soon, or when you want control that a DST trustee is forbidden to exercise.

It can also be right when the gain can be absorbed by other items on your return. Suspended passive losses, capital-loss carryforwards or a low-income year can cut the federal layer sharply (all the ways to reduce tax on a rental sale), and a partial exchange lets you take some cash as taxable boot while deferring the rest (intentional boot).

Breakwater Exchange places 1031 proceeds into DSTs with vetted national sponsors, and the first thing we look at is whether the numbers above favor the exchange at all. Have your CPA or attorney confirm each threshold against your own return before the 45-day clock starts.

• Gain under roughly $250,000 in a no-income-tax state: the federal bill may be smaller than a 10% load on the whole equity.
• Taxable income that stays under $98,900 joint after the sale: part of the gain is taxed at 0% and deferral buys little.
• Cash needed inside five years for a home, a business or living costs: the DST's hold period is the wrong shape.
• You want to renovate, refinance or pick tenants: a DST cannot, by design (why DSTs cannot do value-add).
• You have losses or a low-income year that shelters most of the gain: pay a small bill and keep full liquidity.