If your self-directed IRA has ever received income from leveraged real estate, your CPA or tax professional may have mentioned some additional taxes that caught you off guard. Despite incorporating property into your IRA for the purpose of avoiding taxes, profits yielded from debt leverage may be subject to unrelated business income tax (UBIT). Like most tax-paying Americans, you may have asked yourself, “What can I do to avoid these taxes?”
Per Internal Revenue Code Section 1031, real estate investors may defer capital gains taxes on profits earned from selling a property if the sale proceeds are used to purchase a like-kind real estate investment. These transactions are called 1031 exchanges. Like alternative asset investing in general, most people don’t realize that self-directed retirement accounts can initiate 1031 exchanges in the same manner as non-retirement real estate investors. If executed properly, your IRA or 401(k) could defer or eventually phase out UBIT obligations using this method.
Let’s review an example to highlight how this works. For simplicity, potential income from these properties will be excluded from our hypothetical calculations and depreciation amounts will be rounded up:
As you can see, applying the $75,000 significantly reduced the debt ratio of Property B. However, you may not always have the luxury of extra IRA money to apply toward a real estate deal. Your success in utilizing 1031 exchanges will generally reflect the success of the subsequent investments. Ideally, as a more expensive property, Property B would offer greater earning potential than Property A. This would allow your plan to pay off debt more quickly, potentially eliminate it altogether, and sell the property 12 months later or continue receiving rent payments without any further UBIT concerns. Even if your plan doesn’t achieve full equity, you may still defer UBIT payments until a time you deem more advantageous.
It’s highly recommended that you contact a tax professional to discuss qualified like-kind exchanges under Section 1031 and proper tax filing thereafter. New Direction Trust Company offers a library of educational materials for general information about self-directed investing. You may also give us a call at 877-742-1270 or send us an e-mail at firstname.lastname@example.org with any questions or concerns.