Can I Use the 1031 Exchange for Property Owned in My Self-Directed IRA?

We should first discuss Self-Directed IRAs or Individual Retirement Accounts. The term Self-Directed IRA is a little misleading since all IRAs are technically "self-directed."  What you ask? Yes, because investors decide where to place or deposit their IRA. They can change financials institutions as often as they like merely by requesting an IRA-to-IRA transfer to a new IRS Custodian. 

Self-Directed IRA 

The use of the term Self-Directed IRA is really referring to the ability of the investor to choose or "self-direct" his or her own investments within his or her own IRA. The difference is that many IRA Custodians limit the investment options that investors can invest. 

The wire houses like Merrill Lynch and big banks like BofA, Wells Fargo and Chase limit the investors choice of investments to publicly traded securities like stocks, bonds, and mutual funds. The same goes for online brokerage firms like Charles Schwab & Company. 

Alternative Investments

Some specialty IRA Custodians allow investors to invest in non-publicly traded investments, including real estate, mortgage loans, deeds of trust, tax lien certificates, non-traded REITs, and much more.  These specialty investments are often referred to as non-traditional investments, non-standard investments or "Alternative Investments."  

The retirement industry generally refers to these as Self-Directed IRAs, not because of the IRA Custodian but because of the ability of the investor to choose or "self-direct" unique investments inside of their IRA. 

1031 Exchange inside of a Self-Directed IRA 

This brings us to the question. Can an investor use a 1031 Exchange to defer the payment of taxes within an IRA for real estate that was acquired inside of the IRA and is now being sold. The answer is "it depends."

The IRA is already tax deferred in the case of a Traditional IRA, SEP-IRA or SIMPLE IRA or Traditional Individual 401(k) Plan or tax-free in the cast of a Roth IRA or Roth Individual 401(k) Plan, so the sale of the real estate inside the Self-Directed IRA is either tax-deferred or tax-free since the real estate is held inside of the IRA. The 1031 exchange would not add any value to the transaction.

Enter UBTI or UDFI

However, under certain circumstances, the sale of real estate held inside of a Self-Directed IRA could trigger a taxable event called Unrelated Business Taxable Income (UBTI) or Unrelated Debt Finance Income (UDFI).  UBTI or UDFI would trigger a taxable event and the Self-Directed IRA would have to file a 990-T tax return and may have to actually pay income taxes depending on the circumstances.  

In this case, completing a 1031 Exchange on the sale of real estate could defer the taxable event and avoid having to file a tax return since any taxable event under a 1031 Exchange qualifies for non-recognition of gain.  The 1031 Exchange can often allow the Self-Directed IRA owner to defer the taxable event and provide time to permanent resolve the issue depending upon the circumstances.