The Tax Code Was Built for Owners

Continuing on the theme of private market investing, let's talk about some of the biggest benefits of investing in private markets besides the large returns..Minimizing taxes

Another thing less sophisticated investors miss is the opportunity to minimize taxes, this is almost just as important as maximizing returns so lets spend some time talking about it today.

The tax code is basically a set of rewards for people who fund businesses and build assets. I'm not talking about complicated loopholes or sketchy tax avoidance schemes. I'm talking about legitimate tax advantages that come from the way private investments are structured and how the IRS treats them. These benefits can make a big difference in your returns over time.

Private markets are one of the few places where the IRS will let you stack the deck a little if you structure things the right way.

Theres nothing shady about this, its simply understanding what incentives exist and positioning yourself to take advantage of the incentives, like the people who wrote the rules expect you to.

When you invest in private companies or private funds, you can sometimes get:

That timing piece matters because in public markets most people are reacting. In private markets, you can be plan around these things.

I learned the early ownership lesson through Detroit real estate first (I talk about it in this post). When you get in early, you capture most of the upside. When you get in late, you might still make money, but the big wins have been taken already. The same exact concept applies to startups and private market deals.

When you add  taxes to that picture it gets even more interesting.

Because the public market tax story is pretty simple: buy, sell, pay capital gains taxes. You may be able to use some losses as a deduction but that's about it.

But private markets have a few kinda hidden ways that most folks don't know about. Actually they are not hidden at all, most folks just don't know about them, but they are pretty easy to find.

Qualified Small Business Stock, or QSBS. This is provisions in the tax code that was specifically designed to encourage investment in small businesses and startups. If you invest in a qualifying company and hold those shares for at least five years, you can potentially exclude up to 100% of your capital gains from federal taxes. This is one of the strongest incentives in the entire system.

As long as it's structured the right way. Eligibility, timelines, and paperwork matter. A normal long-term capital gain gets taxed. This is the rare occasion where the system may let you not pay taxes if you followed the rules.

If you sell QSBS you’ve held for more than six months, Section 1045 can let you defer the gain by rolling proceeds into new QSBS within a 60-day window.

So instead of selling, paying the tax, and then starting over, you can keep your capital working. This lets you avoid a tax event every time you want to rotate into the next opportunity. 

If the stock qualifies as Section 1244 stock, losses can be treated as ordinary losses up to $50,000 per year ($100,000 if married filing jointly), instead of being stuck under the tighter capital loss limits.

This is important because capital losses don’t always help you when you need them. Ordinary losses can offset ordinary income, which is usually the income people actually have. So if a startup goes to zero, Section 1244 is one of the ways the tax code might let the loss do something useful.

The core idea is that you can defer certain gains by reinvesting through a Qualified Opportunity Fund.

If you invest capital gains into a Qualified Opportunity Fund within 180 days of realizing those gains, you can defer paying taxes on them a year or until you sell your opportunity zone investment, whichever comes first. And if you hold the investment for at least ten years, any gains from that opportunity zone investment itself are completely tax free.

So let's say you sold some stock and made $500,000 in gains. Instead of paying capital gains tax right away, you roll that money into an opportunity zone fund. You defer the tax bill, your money stays fully invested, and if the fund does well over the next decade, all those new gains are yours to keep without owing a penny in federal capital gains tax.

Some states have no income tax at all, which means your capital gains from private investments are only subject to federal tax. If you live in a high tax state, you might consider the domicile of the funds you invest in or even your own residency when you're planning to realize large gains. It's not for everyone, but if you're dealing with substantial gains, the state tax savings alone can be worth the effort.

Some states offer tax credits for investments in startups and small businesses. I'm talking about actual credits that reduce your state tax bill dollar for dollar. A few states will give credit for 25% or 50% of your investment or more if the investment doesn't work out.

Beyond credits, some states let you write off losses from startup investments against your ordinary income as deductions. The combination of tax credits and deductions makes the risk-reward equation way more favorable for startup investing.

You can use retirement money to invest in private deals, but you need the right setup. Most workplace 401(k)s do not let you buy private deals directly, so people typically use a Self-Directed IRA, or a Solo 401(k) if they have self-employment income.

The tax advantages are pretty straightforward. All the gains from your private investments grow tax-deferred in a traditional IRA or 401(k), or completely tax-free in a Roth version. If you put $50,000 from your Roth IRA into a private company that eventually returns $500,000, you never pay taxes on those gains. Compare that to a taxable account where you'd be looking at capital gains tax on that $450,000 profit, which could easily be $100,000 or more.

What makes this really powerful is the compounding effect. In a taxable account, you have to pay taxes on gains when you sell, which means less money stays invested. Inside a retirement account, 100% of your gains stay in the account and keep compounding. Over a couple of decades, that difference can be absolutely massive. I've seen projections showing that the same investment returns can result in 50% more wealth or more when done inside a Roth IRA versus a taxable account, purely because of the elimination of tax drag.

There are things to keep in mind though.

First, you have prohibited transaction rules. Your retirement account cannot do deals that personally benefit you today, and it cannot do certain transactions with you or close family. If you blur those lines, you can blow up the tax-advantaged status.

Second, some private deals create taxes inside your retirement account anyway through UBTI and UDFI, especially partnership income and leverage. People hear “tax-advantaged account” and assume “no taxes,” but there are some exceptions.

If you want speed and flexibility, a Solo 401(k) can be a strong tool when you qualify, but the plan setup matters, and the rules are not forgiving. This is where you bring your CPA in before you wire money, not after.

If you’re going to step into private markets, do it like an owner, not like a gambler.

I'm not a tax advisor and you should definitely talk to a qualified CPA or tax attorney before making any major investment decisions based on tax considerations. The rules are complex and your individual situation matters a lot. But the basic point is that private markets offer tax advantages that you can't get from public stocks and bonds.

These benefits can add up to hundreds of thousands or even millions of dollars over the long term of investing. When you combine tax efficiency with the potential for higher returns and lower correlation to public markets, private investments look really good for anyone who has the capital and the patience to commit to longer holding periods.

The wealthy have known about these advantages for forever. They're a big part of how generational wealth gets built and preserved. If you have access to private market investments, whether through direct deals, private equity funds, or other vehicles, it's worth understanding the tax side of the equation. Its that extra edge that can take your investing results from good to great.

Cheers,

~Abdul

Hey Hey… I’m Abdul I’m the chaiman of Ajo Angels and Shujaa Capital and I’m on a mission to introduce angel investing to 25,000 black folks over the next five years. I’m doing this with the goal of narrowing the racial wealth gap as well as trying to close the billion dollar funding gap for black founders.

This article reflects personal perspective and experience, not financial advice. Every career and investment path involves different risks and opportunities. Make decisions based on your own circumstances and goals.