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139: Optimizing Your Portfolio with Alternative Investments

We’ve all heard the saying, “Don’t put all your eggs into one basket,” which rings true for building your portfolio. The ideal portfolio consists of more than stocks and bonds – it includes Alternative Investments, like real estate, drilling funds, and value adds. In this episode of Absolute Trust Counsel, certified financial planner Miguel Delgado joins us for a third installment of our financial planning discussion to take a deep dive into this invaluable topic. Together, we’ll discuss the benefits of Alternative Investments, the different types, how to qualify, and how you can get the most out of them. These strategies include qualified opportunity zones (QOZ), 1031 exchanges, and so much more. Don’t miss out – tune in now!

Time-stamped Show Notes:

0:00 Introduction

1:33 We’ve all heard the saying, “Don’t put all your eggs in one basket,” so to start us out, we’re discussing asset diversification and what it truly means.

2:51 Having a diverse mix of stocks and bonds can lessen your risk to an extent, but at the end of the day, they all belong to the same asset class. That’s why, in this segment, we explore Alternative Investments.

5:40 What makes alternative investments less volatile? They’re not affected by the same risks as publicly traded markets, like stocks and bonds.

8:37 Not everyone qualifies for Alternative Investments. Here’s what you need to know.

11:15 Why are Alternative Investments crucial for a portfolio? The number one reason is spreading out risk.

13:09 Press Play as we explore some Alternative Investments and their benefits, starting with drilling funds.

15:37 A Qualified Opportunity Zone (QOZ) investment allows you to defer taxes for an event where capital gain is triggered.

18:35 A QOZ investment and 1031 Exchange are similar but have key differences. Listen in for everything you need to know.

20:41 While QOZ investments and 1031 Exchanges can both be used on real estate assets, one could be preferred over the other, depending on the circumstance. Here’s why.

22:47 Thank you, Miguel, for sharing your incredible insights with us!


Hello and welcome to Absolute Trust Talk. I’m Kirsten Howe, and I am the host of Absolute Trust Talk, which is our podcast here at Absolute Trust Counsel. Today, we have our third episode with my guest, Miguel Delgado. Miguel is a certified financial planner and a senior wealth advisor at Legacy Wealth Management. He works with owners of privately held businesses and high-performing professionals who are looking to find a way to either slow down or spend more time doing the things they love.

By now, if you’ve listened to the prior two episodes, you have heard or seen a lot about Miguel. You already know his credentials. You already know what a knowledgeable advisor he is. So, I’m sharing a little bit about him as a person since we’re talking about helping his clients do more of what they love. On top of his professional life, Miguel is a proud father and husband, and he is passionate about a few things: nature, classical guitar, and personal growth, which are some of my favorite things. He loves hiking, especially while he’s alone. He is a firm believer that a combination of fresh air and solitude leads to great ideas, clarity, and inspiration, and I echo that. Miguel, welcome; first, thank you so much for being here and doing three episodes. That’s very impressive. We greatly appreciate it.

Well, I’m honored. Thank you. We have been talking about the financial planning that you do with business owners. Let’s shift a little to personal financial planning in this episode.

I want to discuss diversification, a term we hear often. What does it mean in relation to a typical stock and bond end-up style portfolio?

Diversification in the context of stocks and bonds and the traditional investment world is another word for asset allocation. We’ve all heard the saying, “Don’t put all your eggs in one basket.” This is investing in multiple types of stocks and multiple types of bonds. What that means is investing in maybe U.S. and foreign stocks; there are large-cap, mid-cap, and small-cap, different styles of stocks, some that are more cyclical, maybe healthcare-related, and other industries. The more broadly diversified, the more you’re allocated into all these different mixes, is how you achieve that diversification. The same thing applies to bonds. Some bonds have higher ratings versus lower ratings, and some have longer duration periods and shorter duration periods, higher yields, and lower yields. You have this whole basket universe of stocks and bonds, and investing in them across the board is typically the idea of how you achieve diversification.

The interesting thing that I wanted to talk to you about goes beyond that. I’ve heard you use the term meaningful diversification, which means something beyond what you just described. It’s a little different than what the typical investment advisor is going to be talking to their clients about. So, let’s hear it.

Yeah, I learned, and I think most advisors learned that well-diversified portfolios, everything I just mentioned – a mix of different stocks and bonds, and the adage, “Don’t put all your eggs in one basket.” But for some clients, that’s not enough because diversification against all of those different stocks and bonds is still invested in a similar asset class correlated to the stock market.

All stocks, regardless of the style or how large they are, are traded on an exchange – at least, most of them are – their value changes daily, sometimes second by second. There could be a lot of volatility with that. Some clients look at something called Alternative Investments.

Alternative Investments are types of investments that are uncorrelated to the stock market and the market. These could be things like owning real estate outside of your portfolio. One of the reasons people even look at diversification is to try to lower risk. Everybody wants to live in a world where we can achieve the highest returns with the least risk possible. That’s the premise of diversifying a portfolio. If we weren’t concerned with risk, we’d put all our money on NVIDIA or the S&P 500, for example. Don’t do that. That’s not my advice. We’re not recommending that.

But, you know, diversification is achieved by achieving something that goes into the Efficient Frontier. It’s more analytical. I’m not going to go too deep into this, but what the Efficient Frontier says is that it allows us to build a portfolio that considers both the risk of the investment and the return. We can plot different investments on this graph, if you will.

By using Alternative Investments, we can drastically reduce the volatility because they’re not going in the same direction as stocks are with the stock market. If the stock market crashes, for example, that doesn’t necessarily mean that the real estate market is crashing. That doesn’t necessarily mean that oil and gas are crashing or all these other different types of industries.

Meaningful diversification to me is going outside of the traditional world of stocks and bonds and really looking at Alternative Investments, real estate, and various other instruments that can more meaningfully diversify the portfolio.

When we’re talking about Alternative Investments not being correlated to the traditional stock markets and the publicly traded markets, is that part of the reduced volatility? Part of it comes from simply the fact that they aren’t publicly traded. You can’t just click a button and your deal is done. Some of the volatility in the publicly traded markets is due to the ease of trading and how quickly the trades can happen. News comes across from CNN or TikTok or whatever, and all of a sudden, there’s a big swing on a particular investment.

Stocks could be susceptible to risk for a variety of different forms. It could be a geopolitical risk; it could be market risk itself, maybe their cash flow performance wasn’t good, maybe they had some layoffs, maybe it’s bad press, whatever it could be. Interest rates, as we saw in 2010, very recently, can affect valuations as well as bond prices and yields. Alternative Investments, not to say that they’re shielded from that, but they’re not always going to be affected by those same types of risks. They may be but under different frames of context. For example, there might be geopolitical risk that affects certain types of stocks, but that same geopolitical risk isn’t going to affect oil and gas, for example, because it’s a completely different type of industry.

Well, we have seen that some geopolitical events cause the entire stock market to go down. I’m thinking in particular about when the Russians invaded Ukraine. That was a big deal across the board, I think, in the stock market.

Another aspect of how risk is reduced with Alternative Investments is that some of these, a lot of these Alternative Investments are not traded daily. Some of them are privately held and often held for a long period of time. It could be one year up to 10 years or even more. So, we’re seeing a different level of volatility. That’s one aspect.

But we’re also looking at sponsors or alternative investment companies that have a good track record and may have done a real estate project, let’s just say. Maybe this is their hundredth real estate project. Maybe they had a small number that failed in the past, but we understand why those investments failed, and the probability of that reoccurring under the current circumstances that we have may be less likely. It also comes down to the management of those investments themselves.

Anyone can buy publicly traded stock. However, these Alternative Investments are for a particular type of investor. Do you want to talk about that?

Yeah, they very much are. You’re right, a lot of this, unfortunately, has to do with access. And I say “unfortunately” because it takes me back to what I wanted to be an attorney to help people who didn’t have access to the right kind of help. But it is true. Once we reach a certain level of income or net worth, all of a sudden, these doors open up to tools that most people don’t even know exist.

To qualify for some of these investments, the first level is what’s called an Accredited Investor. An Accredited Investor can qualify as such in one of two ways, either through income or through their net worth. If we’re looking at income, if they’re single, they have to be making at least $200,000 a year or more. If they’re married and filing jointly, then they have to be making $300,000 or more. From an income level, that’s how you qualify as an Accredited Investor. On an asset level, you have to have at least a million dollars of net worth, excluding the primary residence. You can include 401ks and other real estate properties, take all of those assets, subtract the debts that you have, and get your net worth. If it’s over a million, then you might be eligible for that.

Okay, and these are SEC requirements, the Securities and Exchange Commission, is “protecting” those who are less affluent from making these investments.

Correct. And then it’s up to the advisor to, if you’re working with an RIA, you’re working with a fiduciary. If you’re working with an RIA who’s also a CFP, it’s almost like a double fiduciary. But it’s up to the advisor to do the extra leg work and make sure that, even though you meet the requirements of an Accredited Investor, this means that it’s a suitable investment for you. Maybe, maybe not. Then, you look at concentration limits. Let’s say somebody’s worth 2 million. But maybe that’s all of their assets. Should we invest all of that $2 million into Alternative Investments? Maybe not. There are concentration limits as to how much we should allocate to the alternative investment world in itself and to even the degree of “How much should I invest into one alternative investment?”

Just because you are an Accredited Investor doesn’t mean you should invest in everything. Your financial advisor still has to evaluate whether this is the right decision for you.

That’s right. Aside from volatility, what other kinds of solutions do these Alternative Investments offer to a potential investor?

We talked about the reduction of risk. I want to note something about this. Risk is reduced not because Alternative Investments are safer. By no degree is that an accurate statement. But it goes back to the theory of diversification. If you want to, read about the Efficient Frontier. By meaningfully diversifying the portfolio, we’re able to spread risk. That’s how risk and standard deviation can be reduced. So that’s a big achievement.

These investments, again, have little to no correlation with the stock market or the bond market.

Some of these investments can provide significant tax strategies that, if used properly, can help people save money in taxes in ways they didn’t even think were possible.

Another benefit is that you can invest in some projects directly and have an impact on communities. There are investment projects that are designed – they’re called Value Adds. Think about it – we’ve seen vacant malls around the Bay Area or shopping centers that look like they’re dying or have already died. Some investment companies look at these plots of land and say, “Well, what’s needed in this community? Maybe it’s more housing. Should we redevelop this land into housing? Maybe more affordable housing, maybe housing with shopping areas that people actually want.” So, for those types of value adds, you can invest in projects that impact either the community you live in or other communities you’d like to invest in.

Okay, so we’ve been talking about Alternative Investments. Why don’t we examine a couple of different types and discuss the possible tax strategies or other benefits that they might offer?

There are lots of options. Let’s talk about drilling funds. These are drilling funds into oil and gas. One of the major tax benefits of these investments is that you can get a tax deduction for the investment that goes into these projects. What they use are what are called IDCs, Intangible Drilling Costs. These expenses can be passed on to the investor as a loss, resulting in a tax deduction. Depending on the drilling fund that you go in, these tax deductions can range. They can range anywhere from, say, at the very least, somewhere around 30% to the very highest, maybe 90%. If I’m an investor and I invest $100,000 into one of these investments and I’m at the highest tax bracket, I could potentially save anywhere from $30,000 to $45,000 in taxes for that one investment, depending on what the tax deduction is, what my tax bracket is, and all of that. This is something that we usually discuss with investors, CPAs, or their accountants to make sure that it’s a suitable investment for them.

I can imagine that there could be situations where the client has some event on the other side of the ledger, that’s happening that, “It would be really nice if I could somehow get a tax deduction.” Like, “Having a taxable event this year, wouldn’t it be great if I could somehow get a tax deduction?”

Exactly. A great place where this could be a good fit is somebody who had an extraordinarily high-income year. Maybe they got a much bigger bonus than they anticipated. Maybe they got their salary, their bonus, and some stock options. If they’re in a year where they feel like they’ve made more money than they normally did and next year isn’t going to be exactly the same, a drilling fund could be a good option to consider because it could bring their tax liability down. Even for somebody who’s a W-2 employee and normally thinks I’ve maxed out everything already, there’s nothing else I can do.” Drill funds can be something they can look at. There are some limitations to that, but that could be something they look at as well.

Miguel, let’s talk about a few other examples. I know you’ve mentioned the QOZ you call it; I think that’s Qualified Opportunity Zone. Did I get that right? You got it. Talk to us about what that means and what the possible benefits of that kind of investment could be.

The QOZ is a cousin of the 1031 Exchange in the sense that it allows you to defer taxes for an event where capital gain is triggered. The difference between a 1031 Exchange and a QOZ or Qualified Opportunity Zone is that in a QOZ, you can defer the tax of a capital gain of any kind. It could be a personal investment like your personal residence; it could be stocks, it could be real estate, it could be gold, or cryptocurrency. If anybody has had any capital gain, whether it’s short-term, long-term, personal, or business investment grade, that could be deferred by using a Qualified Opportunity Zone.

The law came about back in 2017, and it was only intended to last about 10 years, and legislation hasn’t passed anything new yet to extend it. But the way it works currently, let’s say I have an asset, could be any asset, and I bought it for $100,000. Now, the asset’s worth a million, so I have $900,000 of gain. If I sell that asset, I’m going to have to pay taxes on that $900,000. If you’re in California, you’re paying taxes on that, as well as federal taxes. If we use a Qualified Opportunity Zone, I could take that $900,000 and invest that in a Qualified Opportunity Zone investment, a fund, or a private deal. The law requires investors to hold that investment for 10 years inside of that QOZ. But what they’re getting is a tax deferral.

This year, the year that the capital gains tax was triggered, is going to be deferred until the end of 2026, so we’ll have to pay federal taxes in 2027. It gets a little complicated because if we’re talking about California, it’s no surprise that it does not recognize the tax benefits of the QOZ. So, they’ll still have to pay capital gains taxes in California. We’re really talking about a federal tax deferral. Unless you live in mostly any other state, we’re deferring the whole thing. So we defer it for basically two years.

We pay the tax, and we hold on to that investment, but the beauty is at the end of the 10 years when the underlying investment is sold, maybe it’s a real estate development project, maybe it’s some oil wells when that project is sold, the proceeds are received 100% tax-free. Oh, that’s fascinating. I like that.

You referred to 1031 as a comparison to the QOZ. I will ask you to talk about that, but that specifically involves real estate. Right, investment real estate. Talk about that as an approach to Alternative Investments.

The 1031 Exchanges where I typically get involved are when there are investors who – and these are typically people in their 50s, 60s, or 70s – may have owned real estate for a long time. They want to exit for a variety of reasons. They’re either tired of managing the property, they need to refinance, but interest rates are too high, they need to retire, and they need the cash; it could be a variety of reasons. But what’s preventing them from selling in the situation that I’m involved in is they don’t want to pay the tax, and they don’t want to do an exchange where they have to exchange it for another property that they’re now managing.

So, we have access to things called Delaware Statutory Trusts, which are different forms of investment. I won’t go into the full details of that here, but it’s a like-kind exchange. It allows them to go into another real estate asset where they don’t have any management responsibilities. We in the industry like to refer to it as mailbox money because, essentially, they’re investing in real estate, usually AAA-rated or investment-grade real estate, where we’re able to oftentimes provide them with better cash flow.

If you have somebody who was renting out some properties and their cash-on-cash return was maybe 1% or 2% after paying the mortgage and proper taxes and property management, a lot of these DSTs are paying anywhere from 3% to 6% in annual income. So the DSTs allow for us to be able to do that, but where that’s different from a QOZ is the QOZ is any asset, the Delaware Statutory Trust is only for investment grade real estate, and I have some examples that I can share as well.

So, the QOZ can be used for any type of asset, including real estate, whereas the 1031 is only for real estate. How would you decide whether a 1031 or QOZ is the better approach when the asset is real estate?

That’s a really good question because it comes up a lot. Usually, when real estate investors are thinking about selling a property and trying to defer tax, the thing that comes to mind, either by them or some of their advisors, is utilizing a Delaware Statutory Trust. However, a lot of times, a Qualified Opportunity Zone could be worth exploring because it comes down to control.

When you do a 1031 Exchange, let’s say I have a million-dollar property, and my capital gains on that is half a million dollars. If I want to defer 100% of that gain successfully, I have to replace that investment real estate with another million-dollar property, at least. I can always go above or below. But if I want to defer the tax fully, I have a million-dollar property that got sold, and I received the proceeds; I have to replace it with something that’s also worth at least a million.

But maybe that business owner wants to do something other than that. Maybe they want some control over how the cash is spent. Maybe they want to sell the property, not pay the taxes on half a million, and then spend the remaining half a million cash on something else.

A Qualified Opportunity Zone might be able to help them with that because in that same example, where somebody owns a million-dollar property and they have a half a million-dollar capital gain, rather than investing a million dollars into the Qualified Opportunity Zone, they only have to invest half a million dollars because that’s the capital gain. The rest, that remaining half a million, they could do whatever they want with that. That’s their cost basis.

It gives them more control. When presented with both options, many investors choose to go with the Qualified Opportunity Zone for that reason. It gives them more control. Not to mention, they’ll be getting a tax-free asset down the road.

Thank you for that explanation. I did not appreciate that from the prior discussion, but you really laid that out very nicely. Thank you.

And thank you so much for talking to us about Alternative Investments. I’m sure this is something that a lot of my listeners know nothing about. Now they know enough to start thinking about it and possibly start thinking about maybe they should talk to you. Miguel, I really appreciate your being here with us for these three episodes. They’ve been so informative. Thank you very, very much.

Oh, thank you for having me.

And thank you all for watching and listening. We appreciate your interest, and we look forward to connecting with you next time.

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