1031 Exchanges and Self-Directed IRAs: Two Approaches to Real Estate Investing

Real estate investors have more than one way to pursue tax-advantaged investing.

A 1031 exchange may allow investors to defer certain taxes when exchanging qualifying investment real estate held outside of retirement accounts, while a self-directed IRA provides a way to hold qualifying real estate and other alternative assets within a tax-advantaged retirement account.

The two approaches serve different purposes. That’s why, for investors interested in building a broader real estate portfolio, understanding both can open up more possibilities for how and where real estate is held.

Here’s how 1031 exchanges and self-directed IRAs work, and the potential benefits of incorporating both approaches into an overall real estate portfolio.

What Is a 1031 Exchange?

A 1031 exchange allows an investor to sell qualifying investment or business real estate and reinvest the proceeds into qualifying replacement property while deferring recognition of certain taxes that may otherwise be due at the time of sale.

Potential 1031 exchange tax benefits include:

• Deferring capital gains taxes, allowing more of the sale proceeds to remain available for reinvestment
• Continuing tax deferral through future qualifying 1031 exchanges
• Providing flexibility to reposition real estate holdings as investment goals change
• Potential estate-planning benefits, as inherited property may receive a step-up in cost basis under current federal tax law, subject to applicable rules

A 1031 exchange also provides flexibility in how investors reposition their real estate holdings. Investors can exchange into different types or locations of qualifying real estate, exchange one property for multiple properties, or consolidate multiple properties into one, provided the exchange meets applicable 1031 requirements.

How to Do a 1031 Exchange

A 1031 exchange must follow specific requirements and timelines.

In a typical delayed (or standard) exchange, an investor sells the relinquished property, and a Qualified Intermediary (QI) holds the proceeds while the investor identifies and acquires qualifying replacement property. Replacement property must be identified within 45 days of the sale, and the exchange must be completed within 180 days of the sale.

Because a 1031 exchange must be established before the investor receives the proceeds from the relinquished property, investors considering an exchange should understand the requirements before closing on the sale.

Learn more about the rules, timelines, and other key considerations of 1031 exchanges with our free, comprehensive guide.

Investing in Real Estate Inside a Self-Directed IRA

A self-directed IRA offers another tax-advantaged way to invest in real estate—this time within a retirement account. Traditional IRA investments  grow tax-deferred, while qualified Roth IRA distributions may be tax-free.

When a self-directed IRA invests in real estate, the IRA owns the property—not the account owner personally.

The account owner identifies the investment and directs the custodian to complete the transaction on behalf of the IRA. Expenses associated with the IRA-owned property  must be paid with IRA funds, while income and proceeds associated with the investment  return to the IRA.

IRA-owned property must be held for investment purposes and can’t be used personally by the account owner or certain other disqualified persons. Other prohibited transaction rules may also apply.

How Both Can Support Your Real Estate Strategy

A 1031 exchange and a self-directed IRA aren’t interchangeable, and using both doesn’t create a special combined tax benefit.

Instead, they can both provide two distinct ways to pursue real estate opportunities across an investor’s broader portfolio:

• Real estate inside and outside of retirement accounts. An investor may own a qualifying real estate investment outside of a retirement account while separately using retirement funds to invest in qualifying real estate through a self-directed IRA.

• Different tax benefits. A 1031 exchange can defer capital gains taxes when qualifying real estate is exchanged, while a self-directed IRA provides the tax advantages associated with the type of retirement account, such as tax-deferred or tax-free growth. 

• More flexibility across real estate holdings. A 1031 exchange provides opportunities to reposition qualifying real estate held outside of retirement accounts, while a self-directed IRA can provide access to qualifying real estate and other alternative investments within a retirement account.

The benefit isn’t necessarily choosing one approach over the other. It’s understanding how each may serve a different purpose within a broader real estate portfolio.

When to Use a Self-Directed IRA vs. 1031 Exchange

Rather than thinking of a self-directed IRA vs. 1031 exchange as competing choices, start with where the investment is held and what you’re trying to accomplish:

Some real estate investors may have a reason to explore one approach, while others may have opportunities to use both for different assets.

Can You Do a 1031 Exchange Inside a Self-Directed IRA?

Generally, a 1031 exchange isn’t needed when an IRA sells real estate and reinvests the proceeds because the property is already held within a tax-advantaged retirement account.

However, specific circumstances can create additional tax considerations. Investors should consult a qualified tax professional regarding whether a 1031 exchange could be relevant to a particular IRA-owned property or transaction.

Two Approaches, More Real Estate Possibilities

Real estate can play different roles inside and outside of a retirement portfolio.

A 1031 exchange may provide a way to defer recognition of certain taxes when exchanging qualifying investment or business real estate, while a self-directed IRA provides a way to hold qualifying real estate within a tax-advantaged retirement account.

Understanding both gives real estate investors a broader view of the options available to them. The key isn’t deciding which approach is better—it’s understanding what each is designed to do and where it may fit.

For investors who own real estate outside of retirement accounts and are also interested in using retirement funds for alternative investments, these two approaches may provide additional flexibility for pursuing real estate opportunities.

Discover how holding real estate in a self-directed IRA can provide tax-deferred or tax-free growth. Find out more about investing in real estate with an SDIRA.

You can also learn how 1031 exchanges can fit into your real estate investing approach. Download our free 1031 exchange guide.

Equity Trust Company is a directed custodian and does not provide tax, legal, or investment advice. Any information communicated by Equity Trust Company is for educational purposes only, and should not be construed as tax, legal or investment advice. Whenever making an investment decision, please consult with your tax attorney or financial professional.

The role of Equity 1031 Exchange, LLC (formerly Midland 1031, LLC) as Qualified Intermediary is limited to acting as qualified intermediary within the meaning of Regulations section 1.1031(k)-1(g)(4) for Federal and state income tax purposes. In this regard, Equity 1031 Exchange is not providing other legal, investment, or due diligence services. The taxpayer/exchanger must direct all investment transactions and choose the investment(s) for the exchange. Nothing contained herein shall be construed as investment, legal, tax or financial advice or as a guarantee, endorsement, or certification of any investments, legal effect or tax consequences of the transfer, conveyance and exchange of the Relinquished Property and/or the Replacement Property.