Does picking a DST in a no-income-tax state save me state tax?

Your home state taxes you on everything, wherever the building is

A DST that follows Rev. Rul. 2004-86 is a grantor trust, and each owner reports income as if owning a slice of the property directly. For state purposes that makes your share of rent and gain income from real property in the state where the building sits.

Residence trumps location. California's Publication 1100 states it plainly: 'California taxes residents on all income regardless of source', and the personal income tax in Revenue and Taxation Code section 17041 applies to a resident's entire taxable income. A California resident who owns part of a Texas building pays California tax on that rent and on the gain when the trust sells.

So the no-tax state does not lower your bill; it only means a second state does not tax the same income. Where the property state does tax it, your home state's credit for taxes paid to other states usually prevents full double taxation. Publication 1100 lists the other state tax credit among credits California allows in full.

The property's state matters most to residents of no-tax states

The rule runs the other way for nonresidents. Publication 1100 says California 'taxes real property based upon where the property is located', and taxes nonresidents on California-source income. A Texas resident who buys into a California DST owes California tax on that share of rent and gain and must file a nonresident return.

The Texas Constitution bars a tax on the net incomes of individuals in Article VIII, section 24-a, and on their capital gains in section 24-b, and Florida's constitution in Article VII, section 5 bars a state tax on the income of its resident natural persons beyond any federal credit. For a Texas or Florida resident, choosing a trust whose buildings sit in no-tax states keeps the whole investment free of state income tax and of nonresident filings. A portfolio trust with buildings in several states can add several nonresident returns; see DST multi-state tax issues.

Claw-back states keep the gain you deferred from their property

California's Form FTB 3840 instructions say the source of gain from California property 'is determined at the time the gain or loss is realized' and 'preserved without regard to when such gain or loss may be recognized'. Exchange a California rental into a Texas DST and the deferred California gain stays California's, and you file Form FTB 3840 every year until it is recognized.

Oregon works similarly for the paperwork: Form OR-24 reports an exchange of Oregon property for out-of-state property and is filed for the year of the exchange and annually until the replacement is disposed of. Other states' rules are on our state pages, such as California and Oregon, and the general question is in does a 1031 defer state capital gains tax.

Worked example: a California owner who moves to Texas

Hypothetical round numbers; run your own numbers with your CPA. You sell a California rental with $800,000 of gain and exchange into a DST whose building is in Texas. While you remain a California resident, the trust's rent is taxed by California each year, and you file Form FTB 3840.

Three years later you move to Texas, and two years after that the trust sells with $300,000 of new gain on your share. You recognize $1,100,000 of gain on the sale. The $800,000 is California-source deferred gain and California taxes it under the 3840 rules. The $300,000 is gain from Texas real property earned while you are a Texas resident, which California does not tax under Publication 1100's location rule, and Texas has no income tax.

Had you stayed in California, all $1,100,000 would have been taxed there. Had you picked a California DST and moved, the $300,000 would still be California-source. The building's location saved tax only because you moved.

Choose the trust for the property, and let state tax break ties

If you will stay a resident of an income-tax state, pick the DST on tenant, lease, debt and sponsor quality, not on the building's state. If you live in a no-tax state, or plan to move to one, give weight to keeping the property in no-tax states too, and count the nonresident filings a multi-state portfolio adds.

Before you identify, ask your CPA which state returns each trust will add, and whether your current state has a claw-back that follows your deferred gain. Residency changes have their own tests; 1031 exchange in another state covers the cross-border mechanics.