Written By: Daniel Gleich

Key Points 

• A 1031 Exchange allows for deferral of capital gains taxes by essentially exchanging one property for another within a 45-day window.
• Investing in real estate with a Self-Directed IRA also enables you to defer taxes on any gains made from your investment. SDIRA account holders can also reinvest any gains into a new property while maintaining tax advantages.
• Utilizing a 1031 Exchange or investing in a property with a Self-Directed IRA generally requires careful planning and adherence to IRS regulations.

If you’re interested in real estate investing, you may have come across the phrase “1031 Exchange.” While a 1031 Exchange may prove to be a successful tax-deferral strategy, there’s another route you can take if you so choose. Investing in real estate with a Self-Directed IRA (SDIRA) opens up exciting opportunities, particularly if you’re able to sell a property for a profit on what you originally paid to purchase it. Not to mention, all gains from investment properties held within your Self-Directed IRA are tax-deferred (if you choose to open a Traditional IRA).

Let’s take a closer look at how SDIRAs and 1031 Exchanges compare:

Understanding the 1031 Exchange

Originating from Section 1031 of the U.S. Internal Revenue Code, the 1031 Exchange serves as a strategic tool in the realm of a real estate investment, primarily designed to facilitate tax deferral. This mechanism is particularly beneficial when an investor aims to sell a property (the relinquished property) and reinvest the proceeds into another property (the replacement property) that is considered to be “like-kind.” The concept of “like-kind” in a 1031 Exchange is quite broad, encompassing various types of real estate, which allows for significant flexibility in investment choices. By leveraging this strategy, investors can postpone capital gains taxes that would otherwise be due upon the sale of a property, thereby preserving more capital for reinvestment.

Completing a 1031 Exchange

A 1031 Exchange begins with the sale of a real estate asset. At this stage, the investor must explicitly state their intention to engage in a 1031 Exchange. A crucial aspect of a 1031 Exchange is the involvement of a qualified intermediary. This entity temporarily holds the proceeds from the sale, ensuring that the exchange process adheres to IRS regulations. 

The investor has a 45-day window post-sale to identify and document potential replacement properties. The purchase of the replacement property must be finalized within 180 days of the original property's sale. The replacement property must meet the ‘like-kind’ criteria, which, in real estate, allows for considerable flexibility in investment choice.

When planning a 1031 Exchange, investors must consider various factors, including the potential growth of the replacement property, its alignment with long-term investment goals, and the dynamics of the local real estate market. The selection of the replacement property is usually guided by its potential for appreciation or income generation.

Understanding Traditional SDIRAs and Their Tax Advantages

When a Self-Directed Traditional IRA invests in real estate, any gains grow tax-deferred. This is generally advantageous for SDIRA holders who actively engage in real estate transactions, offering a valuable method to grow their retirement funds while deferring taxes that could impact their investments’ growth. Investing in real estate through a Traditional SDIRA allows for tax-deferred growth without the need to complete a 1031 Exchange.

For example, let’s say your Self-Directed IRA is already invested in a multi-family unit and you’re receiving those gains back to your IRA (tax-deferred, of course). You can choose to invest your gains into a new property, expanding your SDIRA to holding two investment properties, creating another revenue stream back to your IRA. All gains from both properties remain tax-deferred. Learn more about how to buy real estate with a Self-Directed IRA.

Comparing Self-Directed IRAs and 1031 Exchanges

While both SDIRAs and 1031 Exchanges offer some form of tax-deferral and the ability to hold a wide range of property types, these strategies differ in several ways. A key advantage of using an SDIRA over a 1031 Exchange is that you are not limited to the window of 45 days to identify a “like-kind property.” You can choose to wait a year or even longer until you find that new deal you’d like to reinvest your IRA funds into. Additionally, you’re not tied to the 180-day exchange period if you utilize an SDIRA.

It’s important to note that you cannot access your Self-Directed IRA funds for personal use until you reach the age of retirement - as SDIRAs are designed with the purpose of benefiting you in retirement, not the present day. With a 1031 Exchange, any income received from 1031 exchange property can be used by the investor for personal expenses. While some may see this as a limitation with holding real estate in an SDIRA, this strategy enables the investor to invest in what they know and believe in for their retirement. While they may not be immediately benefiting from their IRA investments in the present day, they can invest with an SDIRA for a potentially secure retirement.

Being Mindful of Fix and Flips

One real estate investment strategy that is popular is the fix-and-flip approach, where an investor purchases a property, renovates it, and sells it for a profit in a short period. While this can be a profitable venture, the rapid turnaround of a multitude of properties can potentially categorize the transactions as a business operation rather than an investment, which could cause short-term tax implications in SDIRAs, potentially triggering Unrelated Business Income Tax (UBIT). Learn more about UBIT in our recent webinar.

In addition, with a 1031 Exchange, frequent fix-and-flips are prohibited, as in this case the properties must also be held for investment purposes. It’s considered best practice to speak with your financial or tax advisor to determine which strategy may be best for you and to determine if you could possibly face any tax implications.

How to Know Which Strategy May Be Best for You

Both 1031 Exchanges and Self-Directed IRAs present sophisticated ways to manage the tax implications of certain real estate transactions. These strategies require an in-depth understanding of both SDIRA regulations and 1031 Exchange procedures, as well as strategic market analysis and foresight. By effectively navigating these aspects, investors can optimize their real estate investments within their portfolios, potentially maximizing the tax-deferred benefits.

If you don’t currently have a Self-Directed IRA, schedule a discovery call with Madison Trust today. We’re here to answer your questions and power your exciting opportunities with our exceptional service.