4 Tax-Advantaged Investing Strategies You’ve Never Heard Of

“You can always be thinner..look better.” - Patrick Bateman, American Psycho.

If you’re always looking for better ways to do something, this article is for you.?

If you listen to podcasts and read books on personal finance, investing, and optimization, this article is for you.

I don’t feel the need to talk about the power of these strategies. They are obvious.

I’ll talk about 4 strategies utilized by high-net-worth individuals and family offices that the average, and even experienced, investor typically doesn’t know about.

It’s important to work closely with your CPA to examine the implications to your specific situation. I am not a CPA and this is not tax or investment advice.?

I simply wanted to share these strategies so that nerds like myself can understand their power and act accordingly.

1. Roth Conversion

You may have heard of a Roth Conversion, but likely not like this.

A Roth Conversion is a transfer of funds from your traditional retirement account, a Traditional IRA or 401(k), into a Roth IRA.?

There are some benefits to doing this that I won’t get into here because there are already plenty of sources on that, but I encourage you to check those out.

I’ll get into something that they don’t.?

The value of a real estate project can be reduced at the start of construction by investment management fees, asset illiquidity, construction risk, transferability restrictions, etc.

A Roth Conversion creates a taxable event at the time of conversion on the value of the funds being transferred.

Combining those two things is a very powerful strategy. Holding a real estate project in your Traditional IRA and converting it to your Roth IRA when the value of that project is marked down.

Many sponsors are catching on to this strategy and offering it to their clients.

This can be compared to a portfolio of publicly traded stocks that have sold off, and the investor takes advantage of this and converts at the lowered value, thus having a lower tax bill than if the transfer happened before the drop in value.

Here are the steps:?

1. Place Investment Through Traditional IRA. Invest in an offering allowing for this type of Roth Conversion feature. This is available through many different alternative investment sponsors with real estate development offerings.
2. Value Adjustment. The value is adjusted and documented by a third-party appraiser/custodian. This can be a significant amount.
3. Conversion to Roth. Funds are transferred from the investor’s Traditional IRA to his/her Roth IRA at the reduced asset value, creating a taxable event.
4. Harvest Returns. Upon completion of the development and stabilization of the asset, the value may increase.

This strategy is ideal for someone in their 40s or 50s who has built up a substantial amount in their traditional retirement accounts. The potential effects are immense.

One important piece is that one does have to allocate for the tax bill that will be due in the tax year the conversion is exercised.

2. DSTs

I have had many conversations with experienced real estate investors who don’t know what a DST is.

A DST stands for Delaware Statutory Trust. It is the legal entity in which you can do a 1031 exchange on a securitized, passive basis.?

Many of you probably already know what a 1031 exchange is, but if you don’t, go do some quick reading on it now. It’s a way to defer capital gains taxes on sold property if rolled into a new property.

But instead of rolling over your gains into another property, you could instead roll them over into one or more DSTs. Or both property and DSTs.

This is a common strategy employed by people who are tired of actively managing their real estate holdings or who never want to actively manage them in the first place and simply want to start a 1031/DST strategy.

An example of a DST could be a 250-unit multifamily asset recently built in a growing area managed by a professional real estate company. A DST investor would own pro-rata interests in the trust that would make him/her eligible for any cash flows or potential capital appreciation on the asset.

At the end of the DST’s life (sale of asset by the sponsor), the investor could choose to roll into new DSTs/properties, do a 721 upreit, or in the case the capital is needed, cash out (taxable event).

A popular strategy employed by investors looking for a generational wealth strategy is “swap ‘till you drop” in which the investor manages this strategy until he/she passes away. Interests are passed on and heirs receive a step up in basis to the fair market value at that time, avoiding a tax bill for both the investor and heirs.

Potential Benefits of DSTs:

• Professionally Managed. Access to the best real estate companies and professionals in the industry. Many DSTs have large institutional investors, so investors are getting access to invest alongside them.
• Diversification. Most minimums for DSTs are $50K or $100K. Depending on the size of the exchange, one could invest in many different DSTs.
• Speed. The process to invest in DSTs can be quite fast, 2 - 5 days typically. So investors needing to identify quickly due to the 1031 restrictions can execute quickly if needed.
• Better Terms on Debt. For investors who have debt on their relinquished property, they’ll need to replace that debt with the replacement DSTs/properties (or invest more cash). Sponsors of DSTs can typically get better terms than individuals when sourcing that debt.
• Estate Planning. Deferring taxes until death avoids the tax bill for the investor and heirs.
• Higher Absolute Yield. When employing a 1031 strategy, the principal amount invested is higher than if the strategy wasn’t implemented. Therefore yield-producing DSTs would allow for larger cash flows to the investor. This could be particularly beneficial to retired investors looking for income.

Another potential benefit is the passive nature of DSTs, however, some may prefer active investments, so I’ll leave that to the investor to decide.

3. Qualified Opportunity Zone Funds

These came about from the Tax Cuts and Jobs Act of 2017. The intent is to incentivize long-term investments in lower-income communities.

There are roughly 8,700 zones in the US designated as opportunity zones. Most QOZ funds invest in these zones through real estate development projects and investors can realize certain benefits.

The main benefits are:

• Deferral of Capital Gains. This deferral is on capital gains from whatever the investor sold out of (including private or public equity) before investing in the QOZ fund.
• Exclusion of Capital Gains From the QOZ Fund Investment. If the investment is held for 10 years, any capital gains are permanently excluded.
• Depreciation Without Recapture - a lesser talked about benefit.

It’s important to note that there will be a tax bill due during the course of the 10-year investment (if the initial deferral is being actualized) (likely in either 2027 or 2029). Allocating sufficient funds to meet that is an important step to consider when utilizing this strategy. Some sponsors aim at returning enough funds earlier on so that an investor would be able to meet this tax responsibility, and these projects often attract capital more easily.

4. Section 1202 QSBS

This one is a hidden gem.?

QSBS stands for Qualified Small Business Stock. To incentivize investments in small companies, gains in qualifying stock are excluded, subject to a cap at the greater of $10M or 10x the adjusted basis of the stock (for stock issued on or after 9/28/2010, with partial benefits before then but still on or after 8/11/1993).

Again, that's no capital gains on up to $10M or 10x your investment.

There are restrictions on this that have to be considered. Here is a summary of some of those for stock issued on or after 9/28/2010:

• The stock must be in a domestic C-Corporation.
• The investor must hold the stock for at least 5 years. If it's less than 5 years, there is a way to roll into new QSBS to meet this requirement (Section 1045).
• The corporation’s tax basis in its assets must not exceed $50M at the time of the stock issuance.
• At least 80% of those assets must be used for its business.

This also applies to many, but not all, states for state taxes, so it’s important to check your state’s position on this.

Needless to say, the potential is quite large with this one. It’s very unknown to most of the people I have mentioned it to outside of the venture capital world. I think we’ll be seeing awareness of this grow in the coming years.

If you have any questions on these, email me at [email protected] .