How To Combine Financing, IRA's and 1031 Exchanges Print
Written by Al Aiello   
Friday, 26 February 2010 16:48

Savvy Tips That Every Investor Should Know and Use To Save on Taxes

Below are three vehicles that can increase the wealth of the real estate entrepreneur.

Seller Financing

Seller Financing is where the owner of the property provides the financing by taking back the "paper" on the property. Because of its many buyer advantages, seller financing often results in a quicker sale at top market dollar. For investors, seller financing allows the deferral of capital gain's taxes via installment sale reporting under IRS Section 453. (However, an installment note does not qualify for a 1031-exchange.)

The Self Directed IRA

A Self-Directed IRA (SDIRA) is just like any other IRA (regular or Roth), SEP or Keogh, except that you decide where to invest the funds, as opposed to some institution. Compared to conventional retirement accounts, your range of options is much broader with a gourmet variety of high-yielding investments of your choice. With an SDIRA you can take just about all taxable investments and convert them into tax-deferred investments. For example, you can make loans and receive the interest income free of taxes.

The 1031 Tax-Free Exhange

A 1031 Tax-Free Exchange (or rollover) is a technique that allows you to defer taxes on the sale of your investment property by acquiring another investment property within certain IRS requirements. Under Section 1031, owners of investment real estate do not have to pay taxes when they dispose of their property -- not even if it has doubled or tripled in value -- so long as they rollover their property into other investment real estate. In fact, the exchange is usually not a direct swap, and in most cases will appear quite similar to a traditional sale and purchase. The main difference is that you pay no taxes on the profit.

Now let's combine all three of these money-making vehicles into one big super play.

That is, combine the SDIRA with the 1031-exchange and seller financing, but without installment sale reporting under Section 453. Here, you still offer selling financing but cash out by having your SDIRA lend the buyer the cash to buy the property. The buyer would then come to the settlement table with all cash (instead of a note). All of the cash could then be placed into the exchange escrow account and qualifies for the 1031 exchange. (Note: An installment note does not qualify for a 1031-exchange, but cash does.)


JR owns an investment property free & clear that can sell anywhere from $90,000 to $100,000. JR's RE agent tells JR that by holding the financing, the property will sell quicker and for the full price of $100,000. At a $100,000 price the outright sale of the property would result in a realized gain of $70,000 which would result in $21,000 in taxes on the sale. But JR does not want to pay these nasty taxes and does not want to hold any "paper" (which does not qualify for a 1031-exchange). Instead, she wants all cash to escrow in a 1031 tax-free exchange and use the cash to buy a superior property. With the 1031, JR will totally avoid paying $21,000 in taxes, which she can use as a down payment for superior property. Assume that JR has over $100,000 in her IRA's.

The Solution for JR:

1. SELLER FINANCING - JR will provide $90,000 seller financing to the buyer and therefore get the full price of $100,000. Assume that the buyer has $10,000 to put down.

2. SDIRA - JR will provide the financing, not by holding the "paper," but by lending the (unrelated) buyer $90,000 cash from her SDIRA (10%, 30 yrs, 7 yr. balloon). The buyer executes a note and a mortgage on the $90,000 financing with the buyer as the mortgagor and JR as the mortgagee. (We'll come back to the SDIRA shortly.)

3. 1031 TAX-FREE EXCHANGE - Instead of a non-qualifying note, the buyer then comes to the settlement table with all qualifying cash of $100,000 ($10,000 down payment and the mortgage of $90,000). With no property debt and selling expenses of $7,000, the net cash proceeds are $93,000, which are escrowed via the 1031. To complete the 1031 tax-free rollover, JR uses the $93,000 as a 30% DP and acquires a replacement property for $310,000, or 3 times more than the property she sold via the exchange. The higher priced property is in a much better location, with a much higher appreciation-rate and is generating substantially more cash flow than JR's former property.

>>BACK TO THE SDIRA - In the meantime JR's SDIRA is collecting monthly payments of $790 on the buyer's note. Most of this payment is interest, but all tax-free. PLUS: The final balloon payment in 7 years will also not be taxed, PLUS: JR can sell all or part of her note for a tax-free profit within her SDIRA. From the full or partial sale of the note, her SDIRA can use the proceeds to buy & flip a bargain property for a quick tax-free profit; lend money at high tax-free, interest rates; invest in stocks; buy a business; flip an assignable agreement and just repeat the TAX-FREE MONEY-MAKING MACHINE!

A Recap of JR's Big Super Play:

Via seller financing, sold the property quicker at top market dollar.

Yet, still cashed out via the SDIRA mortgage-loan to the buyer.

Via 1031, paid NO taxes on the entire cash profit from the sale.

Via 1031, has new property with more appreciation & cash flow.

Via SDIRA, pays NO taxes on all income from the mortgage.

Her SDIRA can reinvest the tax-free income from the mortgage, into more tax-free income.

TAX ALERT: Some practitioners take the position that the above SDIRA loan to your buyer is a "prohibited" transaction. The author disagrees provided that the buyer is an unrelated party and the transaction is truly arms-length and not a sham. Nevertheless, if the transaction is considered to be a "prohibited" transaction, then there can be costly penalties. Check with competent counsel.

TAX TIP FOR ABOVE: Use another unrelated person's SDIRA for the buyer loan, if the above alert is a concern. For further discussion, see Creating Tax-Free Wealth With Self-Directed IRA's.

The above are excerpts from The Real Estate Investor's Goldmine of Brilliant Tax Strategies, A Tax Reduction System And Special Forms Software Package, by Albert Aiello.