It might prove to be a better choice than a 1031 exchange.
Did you know you can buy & sell real estate using a tax-deferred retirement account? It is completely possible to do that if you have a self-directed IRA – that is, an IRA that permits alternative investments.
Why would you involve a self-directed IRA in a real estate transaction? Two reasons come to mind. One, the IRS will let you deduct or write off any contribution you make to most IRAs. Two, if you buy real estate using a self-directed IRA, the self-directed IRA can later sell the appreciated asset without triggering capital gains tax, with the profits of sale flowing right back into the IRA. (An exception may occur if a loan has been used to buy the property.)1,2
So in terms of deferring tax, is this a better strategy than a 1031 exchange? In some instances, yes – but not always. If you need debt financing in order to acquire a replacement property, a like-kind exchange may be the better option. Some self-directed IRAs can leave you with taxable income (read: tax) if you buy a replacement property with a loan. Otherwise, the use of a self-directed IRA is worth exploring.3
Can a SEP-IRA or SIMPLE IRA be used in such transactions? Yes, and that is worth noting because SEP-IRAs and SIMPLE IRAs have considerably higher annual contribution limits than Roth and traditional IRAs.
You can direct up to $53,000 or 25% of your earnings, whichever is lesser, into a SEP-IRA in 2016.
SEP-IRAs can only be funded by employer contributions, and there is a special formula used to determine the yearly contribution for a self-employed individual. Contributions to a SEP-IRA are not taxable, and they are deductible to the employer.2,4
Currently, a SIMPLE IRA allows employee contributions of up to $12,500 annually, and some SIMPLE plans allow additional, yearly catch-up contributions of up to $3,000 for plan participants 50 and older. Moreover, an employer can make matching or non-elective contributions on behalf of the employee. Contributions are not taxed, and the company match is deductible to the employer.2,5
You must abide by IRS rules when using a self-directed IRA to buy & sell real estate. As the benefactor of the IRA, you cannot personally use the real property you acquire or engage in self-dealing. You cannot, for example, buy a home or building with a self-directed IRA, declare yourself the property manager, and pay yourself a management fee. The IRS also lists disqualified persons who may not use or benefit from real estate purchased with a self-directed IRA. This regulation gets interesting: the spouse, parents, grandparents, children, or grandchildren of the IRA owner (and his or her spouse) are on that list, yet the IRA owner’s siblings, cousins, aunts, and uncles can use the property at fair market rent.1,2
The self-directed IRA you own is prohibited from direct and indirect transactions with disqualified persons. In addition to your spouse, parents, grandparents, children, and grandchildren, this particular list of disqualified persons expands to include fiduciaries of your IRA, service providers to your IRA, and any trusts, partnerships, corporations or estates of which you directly or indirectly own 50% or more.2
Lastly, since the self-directed IRA becomes the titleholder to the property, only non-recourse financing can be used. Without a secured loan, you run afoul of the IRS rules.2
A self-directed IRA may offer a creative option to a real estate investor facing a dilemma. It is a little-publicized and little-appreciated one; one that might provide a great answer at the right time.
This material was prepared by MarketingPro, Inc., and does not necessarily represent the views of the presenting party, nor their affiliates. This information has been derived from sources believed to be accurate. Please note – investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering legal, accounting or other professional services. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All indices are unmanaged and are not illustrative of any particular investment.
Citations.
- atlas1031.com/exchange-types/self-directed-ira [9/7/15]
- landthink.com/self-directed-iras-vs-1031-tax-deferred-exchanges/ [9/7/16]
- newdirectionira.com/education/blog-and-articles/blog/can-my-ira-benefit-from-a-1031-exchange-04252016 [4/25/16]
- irs.gov/retirement-plans/retirement-plans-faqs-regarding-seps-contributions [1/22/16]
- irs.gov/retirement-plans/plan-participant-employee/retirement-topics-simple-ira-contribution-limits [1/22/16]