Hard Money Lending: Asset Location

One the biggest determinants of hard money after-tax returns is asset location. For those who are unfamiliar with asset location, it is framework for classifying the account types that investments are held in. One of the main reasons for considering asset location is to maximize after-tax returns (which can differ quite a bit from pre-tax returns).

Research indicates that higher-returning assets should be held in tax-advantaged accounts (such as an IRA, 401k, or Roth version of either) and lower-returning assets should be held in taxable accounts. If two assets have similar return profiles, then the more tax-efficient one should be held in a taxable account and the less tax-efficient one should be held in a tax-advantaged account. This all presumes that there is limited capital in a tax-advantaged account (otherwise investors would put all of their investments in a tax-advantaged account!). In short, tax-inefficient assets with high expected returns should should be prioritized for tax-advantaged allocations.

Hard money loans (and private debt, generally) fits the bill. Net expected returns are typically in the high single digits or low teens (which is on par with the long-term returns generated by stocks). Additionally, private debt is typically very tax-inefficient as it generally taxed at ordinary income tax rates. Even real estate lenders that elect REIT status are still taxed on 80% of their income. Yes, the 20% deduction helps, but not that much. So from a tax standpoint, there is a strong case that hard money lending should be held in a tax-advantaged account.

Every strategy and fund is unique, but I would say that the bar for investing in hard money lending and/or private debt in a taxable account is incredibly high. In many cases, I do not think it makes much (if any) sense to invest taxable dollars in these strategies because the tax drag is so incredibly high.

Risks Of Investing In Hard Money Lending In An IRA or 401k

The question I ask myself is: if I could generate equity-like returns with less risk and volatility, why wouldn’t I do that?

While my immediate answer is that its a rhetorical question, I can think of a few risks and reasons why investors may not want to invest in or concentrate hard money exposure in an IRA or 401k.

  • It’s not necessarily less risk. Sure, lending appears less risky until the defaults start and then that 10% return morphs into 2% return or a -5% return. My perception of risk could be incorrect.
  • Perhaps there are even better opportunities available. If the stock market is down 20-30%, maybe it’s better to invest in stocks. Or maybe it’s better to buy other assets from distressed sellers, such as private equity secondaries.
  • I’ve seen some multimillion dollar 401k’s and IRAs, but many are below $1 million dollars. The minimum investment for many small private lending funds is 100k or 250k. So investors are often giving up diversification in order to invest with a private lender in a tax-advantaged account.

How I Invest My Own Money

Don’t tell me what you think, tell me what you have in your portfolio.

Nassim Nicholas Taleb

As of 2023, the majority of my tax-advantaged accounts are invested in private lending funds. This is not a recommendation, but I’m personally comfortable with the risks that I am taking in order to generate the returns that I expect.

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