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:​

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:​

By investing in an Opportunity Fund, an investor can:​

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.