Wouldn’t it be nice not to pay taxes on the sale of your investment property? Well, depending on the strategy you use, you may not have to! You could use your retirement funds to invest in real estate deferring taxes when you sell the property, or you could do a 1031 exchange and defer taxes outside of your retirement account.
Differences between 1031 Exchanges and Self-Directed IRAs
There are a few differences between 1031 exchanges and self-directed IRA investing. When investing in real estate using a self-directed IRA, you purchase the investment property within your retirement account. When you sell the property held within your IRA, you don’t pay taxes because it is within a tax-sheltered account. There is no specific amount of time that the property has to be held within the IRA before you can sell it. You would then pay all bills associated with the property by using the funds in your IRA. All rental income and sale proceeds get deposited back into the account tax-free. Please keep in mind that there are rules that must be followed. An IRA property is for investment use only. Personal use is prohibited.
A 1031 exchange and real estate IRA both defer taxes when it’s time to sell, but a 1031 exchange has its own setup rules. 1031 exchanges are ideal when an investor sells business-use or investment property for another. Exchanges are not set up until the investor is ready to sell their investment property. You can exchange up in value, exchange one property for multiple properties, or consolidate multiple properties into one larger property. Land can be exchanged for residential property or residential property for commercial. You do not have to exchange into the same type of real estate as your relinquished property (i.e., land for land or residential for residential). If you have multiple investment properties in other states, you can exchange them into one or more properties located in the same state. The options are endless.
Rules of a 1031 Exchange
You need to be aware of your net selling price. The net selling price is the gross selling price minus the closing costs. Your replacement property must be of equal or greater value to the sale price of the relinquished property for complete tax deferral. The IRS says you can identify one to three properties of any value. If you decide to identify more than three properties, then the sum of their market value cannot exceed 200% of what you sold your relinquished property for.
There are timing rules with exchanges. You have 180 days from the closing date on the relinquished property to complete your 1031 exchange. Within the first 45 days of the 180 days, you must identify all intended replacement properties. By day 180, you must close on the properties you identified. You must use a qualified intermediary to complete the exchange (such as 1031 Tax-Free Strategies). The 1031 exchange has to be set up before closing on the relinquished property. Unlike real estate IRAs, 1031 exchange properties can be used for business use, and in some cases, you may be able to vacation in the property for a few days a year (consult with your tax advisor to learn more). With careful planning, you may never need to pay taxes on your properties (call us and ask us how).
A good 1031 exchange candidate has…
- A property held long term (with or without appreciation)
- Property that depreciated (you can avoid depreciation recapture)
- Rental property and will be subject to capital gains and state taxes
A good 1031 exchange candidate is looking to…
- Diversify or wants more cash flow
- Buy a larger or more profitable property or unit
- Downsize from a larger property to a more manageable type of real estate
A good self-directed IRA candidate…
- Wants to own investment real estate
- Wants to flip and resell investment property quickly
- Needs extra funds to purchase an investment property quickly
- Is looking to build their retirement account or diversify their investment portfolio
- Wants to lend money via a note from your IRA
- Wants to invest in other assets such as private LLCs and private stocks
When investing in real estate, consider doing a 1031 exchange or real estate IRA. Both could save you thousands of dollars on taxes on the sale of your investment property. Midland Trust specializes in the administration of self-directed IRAs. Midland 1031 is a qualified intermediary and is also a sister company of Midland Trust. They are also the only 1031 exchange company in Southwest Florida with two Certified Exchange Specialists (CES) on staff.
For questions regarding 1031 exchanges and to reach Midland 1031, call 239-333-1031 or click here to schedule a free consultation.
For questions regarding self-directed IRAs or real estate in an IRA, contact Midland Trust.