Avoiding Tax All Together by Using 1031 Exchange in an IRA

A 1031 exchange allows tax payers to defer taxable gain on exchanges of like-kind assets, such as real estate for real estate. Because money in an IRA can generally flow tax-free from one asset class to another, retirement account holders rarely need to employ a 1031 exchange.

However, some IRAs may have taxable income (and taxes) when assets are purchased with debt financing. In this case, IRA owners may want to take advantage of the 1031 rules, and exchange their first debt-financed property for another. The result of this exchange is that all or most of the IRA income taxes are deferred.

Debt financing allows an IRA to borrow money from a bank (or private lender) to purchase property so that the IRA can have more buying power, and thus purchase a pricier property or more properties in general. For example, with debt-leverage, an IRA with $100,000 can have the buying power of $300,000 or more. Leverage is seldom available with securities investments in IRAs, which is why non-traditional self-directed IRAs provide so many benefits for retirement investors.

To engage in a 1031 exchange, real estate IRA owners will need to utilize a qualified intermediary. Once the sale of your property is complete, the qualified intermediary will receive the cash. The IRA cannot receive the cash, or else it will not be seen as a 1031 exchange to tax courts.

1031 exchanges must also be performed in a timely manner - you must close on the new property within 180 days of the sale of the old property. Within 45 days of the sale of the IRA property, the IRA holder must designate a replacement property in writing to the qualified intermediary.

Many SDIRA investors believe that investing in a cash-flowing real estate property with funds they have available in their IRA maximizes the value of their account. Consequentially, these investors select real estate as an asset after being unsuccessful with traditional retirement investments, like stocks and bonds. Self-directed IRAs allow account holders to make their own best investment choices by utilizing their persona knowledge and experience within the real estate market.

The following scenario was posed by user here on BiggerPockets. Follow the hypothetical below to learn about the interplay of debt leverage, UBIT, and 1031 exchanges to avoid taxes inside a real estate IRA.

Client's Scenario:

• Let's say I buy Property A for $200,000 using 50% leverage ($100,000).
• After ten years, Property A appreciates to $300,000, and my loan balance is down to $50,000.
• Including the loan balance, this means Property A's gain would actually be $100,000, plus any depreciation used by the property.
• Say I then sell Property A for $300,000, and reinvest this money into Property B, a duplex.
• I use the $250,000 of equity from the saleof Property A, plus an additional $150,000 loan for a total of $400,000 using a 1031 exchange.
• The tax on the profit at the time of sale of Property A is deferred until further down the road.
• Now let's say five years later, Property B appreciates to $500,000, and I have completely paid off the loan from operating income.
• Then, I wait one year and a day after paying off the debt-leverage to avoid UDFI taxes on the gains.

The Question:

If I follow the steps above, does it mean that I avoid paying UDFI taxes on $400,000 of gains by using a 1031 exchange, and by waiting the required 12 months and a day after the loans are paid off before I sell Property B?

Answer:

Yes! Because:

• UBIT and UDFI taxes apply only to the percentage of the year's gain that can be attributed to debt-financing.
• Individuals are used to accumulating gains inside 1031 exchanges based on the idea that they're eventually going to have to pay the piper when they sell their property and don’t replace it with a new one.
• IRAs have the exclusive benefit of being able to calculate the amount that is subject to tax based on the amount that can be attributed to debt=leverage.
• So, assuming you pay off the debt a full 12 months and one day prior to the sale, the taxable portion of the gain on that sale is zero, and the piper goes hungry.
• Don’t forget, the pay-off of the debt can come from any assets the IRA owns.
• Investors may direct cash flow from other properties to pay off the debt on one property in anticipation of the sale.
• Investors may transferred funds from other IRAs specifically to pay down debt early, wait 12 months and a day, sell the property with no UBIT, and then transfer the extra funds back to where they came from.
• Of course, the yearly UDFI taxes on operating profit operate differently; this is where depreciation benefits can help.
• IRA investors may often sees taxable losses accumulating in IRAs from a newly purchased property, even though the property is cash-flow positive.

So, how can one avoid tax all together by using 1031 Exchange in an IRA? Comment below with your thoughts.

Like all investments, due diligence is required to decide what will work best for your IRA and its investments. Be sure to ask questions below or check out the other SDIRA related blogs here on BiggerPockets. Thanks for stopping by!