I bought a rental in Hawaii for $600,000 and want to sell it for $1.2 million. How can I avoid paying capital-gains tax?

The house is located in Hawaii, on Oahu. It is a single-family home. I purchased the home for $620,000 and hope to list it for $1.2 million. I am currently employed full-time. I cannot move back to Hawaii to live in the house.

I would like to sell the house sometime this year.

Bored of Landlord Life

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Dear Bored Landlord,

Capital-gains tax varies by state. When you sell your house, you will have to pay taxes to both the state and the federal government. Capital gains are taxed in Hawaii at a rate of 7.25%. And keep in mind, you will also be taxed at the federal level, which ranges from 0% to 20%, depending on the amount and the individual case.

(There is a primary home sales exclusion, which does not apply here because your home is a rental. According to the Internal Revenue Service: “If you have a capital gain from the sale of your main home, you may qualify to exclude up to $250,000 of that gain from your income, or up to $500,000 of that gain if you file a joint return with your spouse.”)

As the home has been an investment property and you’ve collected rental income, you can consider a 1031 exchange for the house to postpone payment on capital-gains tax that you may incur when you sell the home. But you will have to exchange that Oahu rental for some other investment property (it can be another home, or even an agricultural farmland, or a strip mall, or an apartment, and so on). And you’ll still have to be the landlord.

If you’re not keen to swap that out, you can also look into something called a Delaware Statutory Trust, Isaac Kim, a Los Angeles-based financial adviser with Golden State Wealth Management, told MarketWatch. “It’s a really, really good strategy for people who want to cash out and they don’t want to manage a new property,” he explained.

A Delaware Statutory Trust was created around two decades ago. It’s a real-estate ownership structure that functions a lot like a typical real-estate investment trust (REIT). It allows multiple shareholders to hold an interest in the holdings of the trust, but no single owner can take over in its entirety.

The Delaware Statutory Trust will hold a title to one or more investment properties. An existing owner of a multi-family apartment, or a bunch of e-commerce distribution centers, may have set up a DST, and a landlord like you who is selling can swap their rental for shares in the apartment building managed by a property-management company.

Kim explained that if you sell your Oahu house, instead of looking to replace that with another property to satisfy the 1031 requirement, you can use the money to buy shares of the Delaware Statutory Trust and a stake in the apartment building (or whatever the trust is made of).

Austin-based investment property wealth manager Realized, which works with nearly 50 “sponsors” who are companies that put together the Delaware Statutory Trusts and run it, has seen over $1.5 billion from home sellers flow into their properties.

“Our typical client is 55-plus at or nearing retirement,” Trey Robinson, chief marketing officer at Realized, told MarketWatch.

“They have built their wealth through accumulating rental property, investment property and now they want to transition from accumulation to distribution,” he explained. “They either want to move out of the active landlord portion of their responsibility, or they want to start to harvest the wealth they want to start to use it to live on.”

By swapping your home for shares in a Delaware Statutory Trust, you don’t pay capital gains on the $600,000 in profit you will make on the sale of the home per se, given that you’re reinvesting the (potential) $1.2 million in another property. And you will in turn receive income (such as rent) off of that money through interest on a regular basis.

“You don’t have to pay capital-gains tax right now. And you don’t have to manage your property,” Kim said. And it could be a good fit for those who are retired and are “tired of being a landlord and you want to sell,” he added.

But do your due diligence to see if this strategy works for you. Taking this route means your money may get locked up for a few years until a window of opportunity to sell appears. DSTs have long holding periods, Realized wrote in a blog post. It can also be extremely difficult to exit the investment early.

Don’t forget the fees that may be involved with a DST. Plus, a note of caution: Sometimes when there is an investment idea that is difficult to understand, you may end up hiring someone — and paying them — to help you.

So make sure you do your research, and nevertheless, discuss this option with your financial adviser or an attorney who may be able to take a deeper dive into the pros and cons. You don’t want to jump into something just to avoid taxes, and end up in a quagmire later on in life.

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