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Should I Make Investment Decisions Based on Tax Advantages?

We just finished tax season and during this post-April 15 aftermath, people are thinking about how to achieve tax advantage going forward.

A couple of weeks ago, someone asked "should I invest in real estate to offset other income?" The answer is to look at the return on investment of each potential opportunity, totally independently of the tax ramifications and if it makes sense, go for it. If not, think twice.

Remember that when it comes to investing, the primary driving force for making investment decisions should usually be the underlying fundamentals of the investment itself, not the tax advantage(s). Tax advantages are usually icing on the cake, not the cake.

If the investment is not justified without the tax advantage(s), it's probably a marginal investment at best.

I have rentals in my self-directed Roth 401k. It's a beautiful thing. But if the numbers didn't work outside of the Roth, these rentals shouldn't be done, inside OR outside of the Roth.

Don't get me wrong, tax ramifications are important and sometimes very important. For example, if a part-time investor with a full-time job is flipping houses on the side and is classified as a dealer, the investor could be paying almost half of their profit in taxes if the income for his/her primary occupation puts the additional flipping profit in the marginal 25%-28% federal income tax bracket, 5% state/city income bracket plus subject to 15.3% FICA payment.

There is a difference between tax “ramifications” and tax “advantages.”

Until the Tax Reform Act of 1986, high income earners would sometimes make investments, such as limited partnerships for large apartment complexes, that had paper losses for the "tax write off's" to offset income that was taxed at very high rates. The changes in passive income laws and the elimination of the highest marginal tax rates forced investors to modify their investment strategies and decisions more toward the actual viability of the investments as opposed to buying certain "investments" for write off's.

While a go/no-go decision for a given investment is best made on its specific underlying fundamentals and not on taxes, the way that investment is financed may be driven by tax ramifications. A good example is trying to decide whether to do a Roth conversion before making an investment with retirement funds.

Let's say you want to buy a townhouse in distressed condition in a working class neighborhood in your self-directed IRA and fix it up then rent it. Let's further assume that the total cost to buy, fix and hold this property until rented, free and clear, is $80,000. This number is very close to a townhouse bought and fixed last year by my SD 401k, so this is not an unrealistic hypothetical number. For simplicity, let's say that the after-repair value of the townhouse is $120,000, the rent is $1,200/month and the positive cash flow is $800/month after property taxes, insurance, vacancy, maintenance and property management (remember it is free and clear). This investment has a cash-on-cash return of 12% (which is also equivalent to a 12% "cap rate" since it is free and clear) on top of a 50% increase in equity as soon as repairs are finished. These numbers meet the investment criteria of some investors regardless of tax ramifications.

For those investors, the question isn't whether to buy that deal with their SDIRA funds since they would buy it anyway in their SDIRA. The question is whether to do a Roth conversion before buying the townhouse then buy it in their self-directed Roth IRA. Let's say that the Roth conversion of the $80K from the SDIRA to the SD Roth IRA would cost $20K in federal taxes (25% marginal tax rate) and $3K in state taxes (5% marginal tax rate). In other words, the total cost of the Roth conversion would be $23K. Let's also assume that the investor is or will soon be 59 1/2 and can withdraw the positive cash flow now or shortly.

If this townhouse is bought in a self-directed Roth IRA instead of the pre-tax SDIRA, the $9,600 per year of tax-free positive cash flow will return the $23,000 of Roth conversion money in less than 2.5 years (assuming the investor doesn't need the positive cash flow for anything else in those 2.5 years). After that, the $9,600 per year is tax-free for the rest of the investor's life (assuming that the Roth is not repealed by Congress). This doesn't even include the return on the Roth conversion money that comes from the tax savings on increasing the ARV of the townhouse to $120,000 from the $80,000 of cash invested.

In other words, buying and fixing this rental townhouse using self-directed retirement funds made sense even BEFORE tax ramifications. The decision that made sense based on tax ramifications was the financing decision (i.e., the Roth conversion), not the original decision to purchase, renovate and rent.

In summary, when making investment decisions, first look at the basic fundamentals of the investment and see if they meet your personal investment criteria. Once you feel that it is a sound investment, then consider the tax ramifications as additional advantage.

Can there be situations in which the tax ramifications are the dominant factor for the investment decision? It may be possible but I am not an accountant and I am not a licensed financial advisor. So, I am not providing investment advice, tax advice or accounting advice here. I am just an investor talking about common sense.


Biography: Marc Halpern is a successful part-time investor who has achieved financial freedom in terms of passive income and net worth mostly through rentals and flips using “regular” money and self-directed 401(k) funds.

E-mail Marc Halpern directly if you want to improve your profits through coaching by a local expert in South Jersey/Philadelphia with track record.

Do not take any action or make any decisions based in whole or in part on the content of this article. ALWAYS consult with licensed professionals in YOUR state before making any investment.


Now watch the streaming video lectures of Marc Halpern’s Smarter Real Estate Investing Series:

  • Top 10 Essentials for Successful Flipping

  • How to Choose Houses for Rentals

  • Fund a Rental with A Flip: Analysis of an Impressive 2-Deal Case History

  • Landlording: How to Establish Acceptable Standards of Behavior with Tenants, Tenant-Buyers, Other People’s Children and Other Humanoid Life Forms

  • How to Effectively Choose Renovations for Flips and Rentals

  • Should I Flip? Rent? Wholesale? Lease-Option?

  • Advantages of Self-Directed 401k’s vs Self-Directed IRA’s

  • Leverage of OPM: The Good, The Bad and The Ugly in Real Estate Investing

  • Wholesaling from the Buyer’s Perspective

  • Decision Making, Happiness and Daily Lifestyle Aspects of Real Estate Investing

  • How to Recover from Bad Real Estate Deals

  • Overcome Barriers to Buying Your First or Next Investment Property

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