Uncle Sam favors innovators and entrepreneurs.
The tax code is one prime example – with deductions and benefits sprinkled throughout its pages to encourage entrepreneurship vs. punching a clock.
With the right planning, an investor looking to maximize income while minimizing taxes would do well to look at alternative investments.
By leveraging retirement accounts and investing in specific tax-advantaged alternatives, investors will have more income left over for compounding wealth and future generations.
The Private Investment Advantage –
Unfortunately for the individual who works 9-5, the tax code is stacked against them. So while clock punchers can pay up to a maximum federal tax rate of 37%, entrepreneurs generating passive income from investing in private companies could pay the maximum capital gains rate of 20% on both profit distributions and long-term growth.
Let’s compare the tax liability between a CEO of a private company and an investor in a private investment fund.
Both make the same $1M in income per year, but while the lawyer’s income is categorized as earned income, the investor’s is considered passive income.
The investor will pay less in taxes because passive investments like private investment funds are typically set up as partnerships (LPs or LLCs) designed to maximize tax benefits for its partners. Passive profits distributed to the partners are taxed at the individual levels at the capital gains rate.
For purposes of this exercise, we’ll assume the top capital gains rate of 20% for the investor.
Here are their relative tax liabilities:
Lawyer: $370,000.00 ($1M x 37%)
Investor: $200,000.00 ($1M x 20%)
So, while the CEO and investor both make the same amount of income, the exec pays a whopping $170,000.00 more in taxes. The tax code incentivizes capital to create businesses, innovations, and opportunities, which will in turn provide jobs for millions of worker bees taxed at ordinary rates to pad IRS coffers.
An additional tax benefit for private fund investors is the exemption from paying FICA (social security & medicare) payroll taxes. In our example, that’s an additional savings of 7.65% per year or $76,500.00/year.
Taking FICA into consideration, the investor is $246,500.00 less in taxes per year compared to the CEO on the same $1M income. That extra income can be re-invested to grow more income taxed at the capital gains rate and so on.
Gains from the eventual sale or redemption the investor’s partnership interest will also be taxed at the long-term capital gains rate.
Tax Benefits of Private Real Estate Offerings –
Passive investments in private real estate offerings – whether investing directly in a private real estate investment company, through a private equity fund, or a tenancy-in-common – offer an additional layer of tax benefits.
Some of the most common real estate-related deductions include:
- Depreciation (Accelerated)
- Mortgage Interest
- Property Tax
- Operating Expenses
In a private real estate investment fund, these deductions are distributed to their partners on a pro-rata basis and reported on each partner’s annual K-1. Deductions considered passive losses can be used to offset passive income while any other deductions can be used to offset ordinary income to reduce tax liability.
So for the professional still collecting a salary from their day job, a passive real estate investment could even reduce that ordinary tax liability.
Here’s a rundown of the major real estate tax benefits:
- Regular Depreciation. Regular depreciation deductions allow investors a business deduction for the cost of items that have a “shelf life” like a building. The typical depreciable time-period is 27.5 years. For example, if the cost basis of a multi-family property (the building only and not including the land or improvements) is valued at $1,000,000, the annual depreciation deduction allowed over 27.5 years would be approximately $36,400. In a passive investment, this depreciation would be distributed pro-rata to all the partners. The practical effect of depreciation deductions is that a passive investor will pay little to no taxes on their periodic profit distributions.
- Cost Segregation. Cost segregation is a tax strategy that dissects construction costs from the purchase price of the property that would otherwise be depreciated over 27.5 years. Cost segregation is typically conducted by an engineering company and reported on a cost segregation study. The primary goal of a cost segregation study is to identify all property-related costs that can be depreciated over 5, 7, and 15 years as opposed to 27.5 years for the building. This accelerated depreciation allows greater deductions in the earlier years of the life of an asset.
- Bonus Depreciation. One of the major changes from the Tax Reform Act was the bonus depreciation provision, where businesses can take 100% bonus depreciation on a qualified property purchased after September 27th, 2017.
- 1031 Exchanges. A 1031 exchange doesn’t typically come to mind when considering private real estate investment funds but there are options for passive investors to take advantage of this tax benefit that allows a swap of like-kind commercial property to defer the capital gains. Although most private real estate funds are not set up for qualified 1031 exchanges from an investor’s personal property, this same investor could do a qualified 1031 exchange flipping his interest in one private real estate fund to another real estate fund under the same sponsor.
- Qualified Opportunity Zones. As part of the recent Tax Reform and to encourage private investment in distressed communities, the government has instituted significant tax breaks for investors who invest in Qualified Opportunity Zones.
By investing in an Opportunity Fund, an investor can:
- Defer taxes on the original capital gain until the end of 2026.
- Reduce up to 15% of the tax bill on the original capital gains if remain invested in the Fund for at least 7 years.
- Eliminate the tax on any appreciation (new capital gains) on the original investment after the 10-year mark in the Opportunity Fund.
For Investing Tax-Free Remember the Name Roth
Many investors know about the tax benefits of investing in real estate, including the long-term capital gains benefits as well as the various regular and depreciation deductions available for commercial properties.
While most investors are familiar with the capital gains deferral benefits of 1031 exchanges, many are unaware of the tax deferral and even the tax elimination benefits of investing through a Solo 401 (k) or a Self-Directed IRA (SDIRA).
A Solo 401(k) plan is an IRS approved retirement plan, suitable for business owners who do not have any employees, other than themselves, and perhaps their spouse. It is a traditional 401(k) plan covering only one employee.
A Self-Directed IRA is an IRA that gives you control over your investments. Unlike other IRAs held at banks, brokerage firms, and other institutions, you’re not limited to stocks, bonds, or mutual funds.
Both the Solo 401(k) and the SDIRA allow you to invest in alternative assets including real estate, private investments, limited partnerships, commodities, etc. This is what distinguishes Solo 401(k)’s and SDIRAs from 1031 exchanges, which are limited to direct real estate investments.
Solo 401(k)’s and SDIRA’s both offer traditional (tax-deferred) and Roth (tax-free) options. Whereas the traditional options are funded with pre-tax dollars, the Roth options are funded with after-tax dollars. The main advantage of the Roth option is that the gains are TAX-FREE.
There are significant tax benefits to investing in alternatives – especially through private investments.
Then pairing these alternative investments with a retirement plan such as through a Solo 401(k) or SDIRA could result in significant tax savings – especially through the Roth options where gains can be accumulated and withdrawn tax-free.