A self-directed IRA and a 1031 exchange can both let you defer taxes when selling investment real estate. However, the differences can help you choose. There are complex rules to follow, alternative investments to consider and tax implications that can affect your bottom line.
Whether you’re looking to sell a rental property or diversify your investments, this article explains what you need to know.
Self-Directed Real Estate IRA vs. 1031 Exchange
A self-directed IRA (SDIRA) is an IRA account you directly control while a custodian administers the account. With an SDIRA, you can invest in alternative assets not allowed in other IRAs, including precious metals, cryptocurrency and real estate, with real estate being one of the most common investments. Because you directly manage the account, you’ll have to do your due diligence regarding which investments to make. You still have a custodian for the funds.
A 1031 exchange is a process that allows you to sell your investment property and buy another investment property with the proceeds to defer capital gains. The name comes from Section 1031 of the Internal Revenue Code (IRC). You must have a qualified intermediary (QI) for a 1031 exchange since you cannot receive any payment for the property sale yourself. This QI is responsible for holding and receiving payments for the properties involved.
Rules for a 1031 Exchange
Although it can be advantageous if you find a property worth investing in, the downside of a 1031 exchange is that you need to abide by a set of rules to perform the swap successfully. This reduces the convenience when investing in real estate, unlike if you invest with self-directed IRAs.
Here are the important points to remember with 1031 exchanges:
- You must buy a like-kind asset. If you sell real estate, you must also purchase real estate of equal or greater value.
- You must work with a 1031 exchange mediator who can hold your cash from the sale of the property until you have found a replacement property.
- You have 45 days to designate a replacement property and can designate up to three different properties.
- You must close on one of the three replacement properties within six months.
- If you do not use all the profits from the sale to purchase the new property, you will be taxed on the difference. Any debt discrepancy will also be taxed — for instance, the difference in mortgage amounts.
Eligibility for Self-Directed IRAs vs. 1031 Exchange
Eligibility for a self-directed IRA depends on whether you’re setting it up as a traditional IRA or a Roth IRA. Income is not a deciding factor for traditional IRAs as long as you have taxable compensation, while there are income limits to qualify for a Roth IRA.
Eligibility for 1031 exchanges pertains more to the property than the investor. For instance, only real estate investments qualify, not property for personal use. You must also follow the rules to complete a qualified exchange.
Why Is a Self-Directed IRA Better for Real Estate Investing?
When choosing between a 1031 or real estate IRA, consider the implications of both regarding taxation, diversification and flexibility with investments. A self-directed IRA is often the better option, but here’s a breakdown of the differences.
Tax Benefits
Because a self-directed IRA can be set up as a traditional IRA or a Roth IRA, the same tax implications apply. This means all gains from the sale of real estate are tax-deferred in a traditional SDIRA or tax-free if you have a Roth IRA. Additionally, you pay taxes on withdrawals from a traditional IRA at your regular income tax rate, which is generally lower than the capital gains rate.
With a 1031 exchange, you must follow all the specific guidelines for your taxes to be deferred. If you sell a property and have excess profits after buying another, this excess is called a “boot” and is taxable.
Diversifying Investments
Unlike 1031 exchanges, selling a property held in a self-directed IRA does not require you to buy a like-kind asset. So, you can buy gold or silver with your IRA account if you prefer. You can use the profits from the sale of the property to buy another property, but you don’t have to. If you want to get out of the real estate business, an SDIRA is a better choice than a 1031 exchange. In addition to precious metals and cryptocurrency, you can invest in private debt and private equity.
Note that the IRS prohibits some types of investments with self-directed IRAs, including life insurance and collectibles like artwork, antiques and gems. In general, self-directed IRAs provide access to a large diversity of investments.
Flexibility in Investments
A self-directed IRA is more flexible with the variety of investment options to choose from. You can mix and match real estate with other investments and all the profits can still be tax-deferred. You can use a portion of the profits on another property and the remaining funds on precious metals like silver.
With a 1031 exchange, all the profits must go to another property of equal or higher value, or you will be taxed on the remaining profit. This is why 1031 exchanges can be tricky since the chances that you’d find a buyer with a suitable property aren’t always high.
Additionally, 1031 exchanges have strict time limits. You must identify a replacement property within 45 days, and you must complete the exchange within 180 days of the sale of the relinquished property, not 180 days after identifying a replacement property.
There is no time limit to purchasing properties or other investments with a self-directed IRA.
Make the Best Choice for Your Real Estate Investments
Both self-directed IRAs and 1031 exchanges can be excellent options for investing in real estate. However, a self-directed IRA may be the better choice since you get more investment options, making room for diversification. Plus, you get to free yourself from rules such as following a specific timeline.
If you’re ready to take the next step, Accuplan Benefits Services can offer expert guidance and support. We specialize in self-directed IRAs and understand the rules involved, so you won’t have to risk disqualifications or misunderstand taxation.
We’ve worked with clients since 1985, so you can count on our vast industry knowledge! Contact us to learn more today.
Disclaimer: Our information shouldn’t be relied upon for investment advice but simply for information and educational purposes only. It is not intended to provide, nor should it be relied upon for accounting, legal, tax or investment advice.
