You may not be familiar with so-called “1031 Exchanges” (named such after the section of the Internal Revenue Code that authorizes them). A 1031 Exchange provides an exception to the tax laws by allowing you to postpone paying taxes that are due on the gain realized from the sale of real estate if you immediately reinvest your proceeds in a similar property as part of a qualifying like-kind exchange.
Note that simply selling a property and buying a new property will not qualify as a Section 1031 exchange. In order to avail oneself of this tax code benefit, the purchase and sale transactions must be mutually dependent upon one another. For many investors, using a third-party facilitator or intermediary to help structure the transaction is the best way to ensure legal compliance.
Applicability to Investments Within Self-Directed IRAs. You may be wondering why a section 1031 exchange could ever be relevant to their self-directed IRAs. After all, aren’t IRAs and the investment activities therein tax-deferred (in the case of a traditional IRA) or tax-free (in the case of a Roth IRA)? While that’s generally true, strictly speaking not every IRA activity qualifies for these tax benefits.
Debt Financing Triggers UBTI. Individual retirement accounts are only tax advantaged to the extent that they engage in activities that are related to their primary purpose. By law, this means that any income or gains that are generated from debt financing will not be exempt from current taxation. Therefore, if your self-directed IRA borrows money in order to purchase real estate, then the portion of the income and investment gains that are attributable to the financing will be subject to current year taxation.
If you’ve held investment real estate within your self-directed IRA for a long time, and you used to financing to acquire it, then a straightforward sale of a property may trigger a significant tax bill for you in a year of sale. And remember that this tax liability can’t be satisfied using funds from within the IRA (at least not without triggering potential early withdrawal penalties).
Using a 1031 Exchange to Defer UBTI Tax Liabilities. Let’s say your self-directed IRA holds a piece of real estate that has significantly increased in value, but the market conditions are such that you believe now is the time to dispose of the property and blocking me. If your IRA used financing to originally purchase the property, the potential tax liability might be a financial disincentive for you to make your desired investment decision. But by using a 1031 exchange within your self-directed IRA, you’ll postpone having to pay for those UBTI liabilities until years (or possibly even decades) later.
Understand that section 1031 transactions are relatively specialized, and should not be undertaken without a certain amount of due diligence beforehand. In addition, many investors find that using professional assistance is the best way to make sure that things go smoothly.