BUY PROPERTY AND TRANSFER YOUR EQUITY WITHOUT PAYING CAPITAL GAINS TAXES
What is a §1031 Exchange?
A §l031 Exchange is a transaction in which a taxpayer is allowed to exchange one investment property for another by deferring the tax consequence of a sale.
The transaction is authorized by §1031 of the IRS Code.
The IRS Code actually reads: "No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like kind, which is to be held either for productive use in a trade or business or for investment."
Requirements for a 1031 Exchange
• Timelines for a 1031 Exchange
The investor (or exchanger) must follow the strict 45- / 180-day guidelines for an exchange. Once the exchanger sells his/her property (relinquished property) he/she has 45 days to identify property(s) of equal or greater value. Once identified, the exchanger has 180 days from the day he/she sold their property to acquire the property(s) identified (or 135 days from the end of the 45-day period).
• Like-Kind Property in a 1031 Exchange
The investor must acquire "like-kind" property. This means that it must be other qualifying forms of real estate. For example, the exchanger could sell a duplex and purchase a commercial property, or he/she could sell a piece of land and buy an apartment building. The property just needs to be "like-kind."
• Exchange Property Held for Investment
The property sold (relinquished property) and the newly acquired property (replacement property) must be held for investment or business purposes. Therefore, you cannot sell your primary residence and buy an investment property, nor could you sell and investment property and purchase a primary home.
• Equal or Greater Debt and Equity in a 1031 Exchange
If the exchanger sells a property for $1 million, in which $500k was equity and $500k was debt, then the exchanger needs to purchase $1 million or more worth of property. Furthermore, the exchanger needs to use all the equity and replace all of the debt to defer 100% of the capital gains taxes.
The exchanger may add additional proceeds to the new purchase if he/she wishes and the exchanger can take on additional debt if desired as well. If the exchanger does not wish to use all of the sales proceeds he/she may do a partial exchange and pay the applicable capital gains taxes on the difference. This is referred to as "boot."
• Constructive Receipt and Qualified Intermediary for a 1031 Exchange. The exchanger may not receive cash from the sale. This is known as "constructive receipt" and would trigger a taxable event on those monies received. According to the IRS safe harbor provisions, the exchanger must use a Qualified Intermediary or QI to facilitate the 1031 transaction.
The QI is an independent 3rd party (not your attorney, agent, broker or CPA) who holds the sales proceeds and purchases the replacement property on your behalf. It is extremely important in today's environment to associate only with reputable, insured and bonded qualified intermediaries.
• 1031 Exchange Risk
As with any investment in real estate, there are risks associated with 1031'S and all investment vehicloes, always consult your attorney specializing in 1031 code or real estate investments.
SELF DIRECTED IRA
Want to use a self Directed IRA to invest in residential real estate? These Self-Directed IRAs allow you to invest in real estate, precious metals, notes, tax lien certificates, private placements and many more investment options.
A Self-Directed IRA is a traditional or Roth IRA in which the custodian permits a wide range of investments that are allowable in retirement accounts. One of these alternative options, real estate investments, is appealing to many people who consider using a Self-Directed IRA to purchase rental properties.
However, just because something is allowed by the IRS does not always mean it is the best choice for a portion of your retirement savings. Here are some important things to be aware of when it comes to using an IRA to purchase real estate.
What Is a Self-Directed IRA?
The term “self-directed” means that alternative investments are accepted or offered by the IRA custodian. An IRA custodian is the financial institution responsible for record keeping and IRS reporting requirements.
The “self” directed aspect kicks in each year since you must accurately value your investment annually and report the value to your IRA custodian.
How Self-Directed IRAs May Be Used to Buy Real Estate
The first steps when using an IRA is to set up a Self-Directed IRA. Several reputable companies provide individual investors with the ability to set up self-directed retirement accounts.
Due to the complex nature of Self-Directed IRAs, it is helpful to have a custodian that will help provide some much-needed guidance as you travel through the murky and confusing waters of the IRS tax code.
Some IRA custodians have more complicated fee structures than others. Therefore, it is important to do your homework and examine all of the potential fees and expenses that will impact the overall return on your investment. In many cases, it is advisable to also establish a limited liability company (LLC) or other entity to hold the investment assets.
With Self-Directed IRAs, you must generate sufficient cash flow that will cover all maintenance and repair costs without the need for you to add cash each year.
Primary Benefits of Owning Investment Real Estate in an IRA
Perhaps the biggest benefit of using a Self-Directed IRA to purchase real estate is found in the potential tax benefits. As is the case with any investment in your IRA, you benefit from tax-deferred income until the day you take withdrawals, or if your investment holdings are in a Roth IRA, your investment gains get to accumulate tax-free and you are able to withdraw it tax-free. You still must wait until you reach age 59 ½ to withdraw your funds without being subject to an early withdraw penalty and having that included as ordinary income on your tax return.
But active investors may buy, sell, or flip properties and move funds from one project to another and still maintain the tax-deferral status of the IRA.
Another benefit of owning real estate in an IRA is the familiarity. Investor interest is often sparked by global market uncertainty and this can lead investors to stick with more local investments. Self-Directed IRAs provide you with an ability to invest in investments that you know and understand.
What Are the Biggest Downside Risks?
As an account holder in a Self-Directed IRA you are responsible for doing the required due diligence on the property itself. This may be an appealing feature of real estate investing in IRAs if you are a real estate professional or experienced investor. However, it could lead to a bad investment decision or the potential of being a victim of fraud if you are not a savvy real estate investor.
The Securities and Exchange Commission (SEC) has released an investor alert addressing Self-Directed IRAs and the risk of fraud.
One of the biggest risks of owning real estate in a Self-Directed IRA is the potential lack of diversification. While not impossible for super savers who have accumulated substantial amounts of wealth in an IRA, many investors lack the ability to create a diversified real estate investment portfolio. Only focusing on the upside potential is a major risk to consider before purchasing an investment property. Liquidity is another big concern when investing in real estate within an IRA. There is always a possibility that you may not be able to access the value of your investment to make distributions when you may need the money the most during your retirement years.
Are There Any Potential Tax Pitfalls?
Owning real estate in an IRA allows your investment to grow on a tax-deferred basis (Roth IRAs provide the potential for tax-free growth). However, if you don’t follow the rules and purchase property the wrong way within an IRA you could disqualify the IRA and create a taxable event. IRA ownership of investment property also loses some of the tax breaks available to real estate investors if the property operates at a loss. You also cannot claim depreciation on IRA-owned real estate.
If you are thinking that an IRA could be used to purchase a vacation home or a primary or secondary residence…think again! Self-Directed IRA investment transactions involving real estate must all be arm's length transactions. This means that no self-dealing or personal transactions are allowable with Self-Directed IRAs. This rule also applies to immediate family members. So, don’t think you can buy or sell property to or from a family member or yourself unless you want to create a taxable event.
Unrelated business income tax (UBIT) is another potential tax issue. This will be important to pay attention to if you are thinking about the use of a mortgage to purchase an investment property.
With a traditional IRA you must take required minimum distributions once you reach age 70 1/2. If you own real estate in an IRA, it is very difficult to sell off your real estate holdings in small chunks each year. That is the reason you must have enough cash in your IRA accounts to cover your required distributions to avoid tax problems.