Learning is an electrical function of the brain. When we first start learning something, our brains start developing connections to integrate that information. Over a period of time, those electrical connections become stronger and stronger giving the perception of something becoming second nature.
It isn’t until a basic function becomes second nature that you can then start adding layers. For example, a professional baseball player was, at one point, an infant who couldn’t walk. Eventually he went on to develop his athletic prowess to the point where he might even chew tobacco while hitting a hundred mile an hour baseball with a piece of wood. At that point, he doesn’t have to think about how to walk anymore.
You see, expertise in things requires depth of experience that allows for complex neural circuitry to form and to make certain, more basic skills, run on autopilot. At that point, you are able to absorb information in multiple dimensions—some conscious and some not. This next level in learning allows us to function at a higher level.
So how does this relate to investing? Well, becoming a sophisticated investor requires some of the same layering of information and development of neural circuitry to allow for a more comprehensive approach to personal finance.
I’ve talked before about how novice investors are often attracted to the “good from far but far from good” investments. You know—the kind with big front end cash on cash returns that then depreciate to zero in just a few years.
Seems obvious to avoid such things but cash on cash is a simple thing to cling on to for novice alternative investors after reading books like Kiyosaki’s Rich Dad Poor Dad. It represents the metaphorical “learning to walk”. Over time, the successful investor starts layering depth and complexity to his investing strategy. He might even start paying attention to the more nuanced lessons in the Kiyosaki books that are often overlooked at first glance.
I will admit whole heartedly that there was a time several years ago that I was just “learning to walk”. There is no shame in that. Over time, I just spent so much time thinking about this stuff that I got more sophisticated than most when it comes to thinking about money. That said, I’ve been around for a long enough time to know that five years from now I’ll be a hell of a lot smarter than I currently am!
Now, over the last several years, one of the most critical elements of investing that I have learned is to understand the importance of the interplay between deploying capital and taxes. In fact, I would say that taxes play a DOMINANT role in my investing decisions and, for that matter, my life decisions.
Let me give you an example of what I mean. Say I earn $100K that I can deploy however I wish. For better or for worse, the first thing that comes into my mind is the fact that a big chunk of that is going to get sliced off and sent to the government in the form of income taxes. That is, unless I do what the government wants me to do like invest in real estate.
You see, the tax code is largely a series of tax incentives. If you do what the government wants you to do, you will will be rewarded by paying less taxes. What does the government want you to do? It wants you to stimulate the economy through business activity and investments into things people need like a roof over their head.
If I want to keep as much of my earned money as possible, I personally invest it in real estate. With cost segregation analysis and bonus depreciation, my investments not only serve to build my wealth in the future, but also decrease the amount of money I have to give to the government today. That is one hell of an incentive to ignore!
Now compare that to investing your hard earned money into another opportunity that might be appealing but not so tax advantaged. For example, a lot of people in the alternative space really like debt funds that pay higher cash on cash returns than other investments. I get it—returns look great. But the way I see it, if I invest in real estate equity instead, not only do I get the benefits of tax sheltered income, but I also get to largely write off the invested capital itself! And don’t forget, investing in real estate also gives you the upside of appreciation.
Investing in debt has NONE of those advantages. I’m not saying don’t do it—just look at it like a multidimensional investor rather then a rookie investor seduced by big cash on cash returns. Think about your investments holistically.
Earlier, I mentioned that the tax code has not only influenced my investing decisions but actually some life decisions as well. You see, after I left medicine, I had to decide where to focus my time. I was already investing in real estate and enjoyed it so one of my options was to become a full time real estate professional.
A real estate professional, defined by the IRS, requires a minimum of 750 hours documented real estate activity per year with no other activity that you spend more time doing. If you meet those criteria, the tax benefits are HUGE. Specifically, all of those passive losses you get from investing in real estate become “activated” making them applicable to any other source of income that you or your spouse (if filing jointly), may earn in a given year. If you don’t understand what I just said, read this paragraph again. It’s huge and it was one of the major reasons that I decided that the best option for me was to become a full time real estate professional.
This designation is particularly good for people selling businesses looking for new careers. The sale of a business often comes with a significant liquidity event.
Say you were one of the lucky ones and sold your dental practice for $10 million. What if you then decided to focus the rest of the year on going full time into real estate investing and became designated as a real estate professional? Well, all of that money gained from the liquidity event could theoretically be invested into real estate and, with bonus depreciation applied to offset capital gains, you may not have to pay any taxes at all!
That’s not theory. That’s reality and it’s totally legal. I’ve seen it done over and over again. I just wish everyone with a big liquidity event knew that it was an option. Think of how much money you could save if you were in that situation!
That’s why I say that being a good investor requires a tax strategy. The emphasis should be not on what you make, but what you keep (after taxes). Like a business, you can’t focus on your top line and never think about your expenses. If you are like most people, taxes are your biggest expense. Run your personal finances like a business and a lot of things will become more clear.
Of course when I finished surgical training a decade ago, none of this was remotely on my radar. It wasn’t until a couple of years later after following Robert Kiyosaki that I discovered a book that would fundamentally reshape my thinking about taxes. The book, Tax Free Wealth, was written by Robert Kiyosaki’s CPA, Tom Wheelwright. Tom is a genius and has taught me a great deal over the past few years. Now, I’m happy to call him my CPA as well.
The more you listen to Tom, the wealthier you will become. So listening to my interview with him on this week’s Wealth Formula Podcast should be a no-brainer.
Tom Wheelwright is a CPA, CEO of WealthAbility (Tempe, Arizona) and Best-Selling Author of Tax-Free Wealth. Wheelwright is a leading wealth and tax expert, global speaker, and Entrepreneur Magazine Contributor. Tom is best known for making taxes fun, easy and understandable, and specializes in helping entrepreneurs and investors build wealth through practical and strategic ways that permanently reduce taxes.
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