Avoiding Tax Altogether by Using 1031 Exchanges in an IRA

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Did you know retirement investors can utilize a 1031 exchange for the benefit of their self-directed real estate IRAs? The following scenario was posed by a client to New Direction Trust Company IRA's client rep team in an email. 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?

New Direction Trust Company's 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.
  • New Direction Trust Company has seen investors direct cash flow from other properties  to pay off the debt on one property in anticipation of the sale. 
  • Clients have 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.
  • New Direction Trust Company often sees taxable losses accumulating in IRAs from a newly purchased property, even though the property is cash-flow positive.

If you have any questions about this scenario, or you would like to propose your own scenario, please call New Direction Trust Company at 877-742-1270 or email us at info@ndtco.com to discuss the rules and benefits of any self-directed IRA investment proposals.