May 30, 2024

Tax planning for alternative investments

With alternative investments growing rapidly, financial advisors and tax professionals are likely to face more questions about IRS and state filings and the potential impact to clients’ returns.

Investors and their advisors often seek out alternative assets such as real estate, private equity, hedge funds, venture capital, certain infrastructure vehicles and — increasingly these days — private credit instruments for diversification outside of daily stock and bond volatility and for higher yields than traditional investments. For those newer to those asset classes, though, the advantages may look much less appealing when it’s time to gather data from the accompanying Schedule K-1 for the investment or when certain clients find themselves liable for payments on their unrelated business taxable income, according to tax experts.

The tax questions relating to alternatives carry major implications to filing and payments. For example, if income unrelated to the tax-exempt purpose of an individual retirement account, a nonprofit, an endowment or a private foundation grows high enough without a corresponding tax payment, the IRS could even use “the really big stick” of revoking duty-free status, said James Ouderkirk, a director for turnkey alternative investment platform GLASfunds.

“It is complicated, and you will want people who have done it and a thoughtful partner,” Ouderkirk said in an interview. “You will want ways to make your life easier when it comes down to doing your taxes, and that’s something we address every day.”

READ MORE: 16 tips about filing for an extension past Tax Day

Ouderkirk’s firm provides investors and their advisors with a universal K-1 that covers the federal side of the tax filings, and the company also offers the option to elect for it to make any necessary state-level payments that could catch some clients off guard, he noted. Other investment technology firms that have sprung up in recent years with services to help advisors and clients with the tax reporting for alternatives include CAIS, Canoe and Arch.

While every client is different and may require specific planning for their needs, they should all think carefully about the potential tax impact of an alternative investment and understand that the reporting aspect of the vehicles is “often less-discussed and can create friction during the tax preparation process each year,” said Alejandro Nazario, a partner with Houston-based TOS Advisors.

“Investors in the United States that invest in certain partnerships and other privately held investments may deal with the notoriously challenging tax Form K-1 or K-3, among others,” Nazario said in an email. “Accountants may charge more to process these forms relative to other, simpler tax forms. As a result, for investors who commit to many partnership investments, they should expect these forms may arrive later than other tax forms and they should be prepared to file extensions on their tax returns, as well as paying more to their tax preparation team to file their returns.”

Another common area of surprise for some investors and their advisors comes from effectively connected income, which creates a tax liability for foreign investors with U.S. holdings, according to Ouderkirk. For investors who might have “never had a U.S. tax filing consideration,” they may be “now triggering an incremental and probably costly” one, he noted.

Within alternative assets, affordable housing financing, long-term capital gains from private equity and venture capital strategies, some kinds of municipal infrastructure and private credit instruments each display some tax-efficient characteristics, Ouderkirk noted. 

“We have advisors who invest in all manner of strategies across the platform,” he said.

READ MORE: Morgan Stanley: Up to 25% of portfolios could be in private markets

Advisors and investors considering an alternative investment will want to answer questions such as: “How will returns be characterized for tax purposes? What are the tax reporting requirements? If investing through a nontaxable entity, are there unrelated business taxable income considerations?  Will there be foreign tax reporting requirements if there is offshore or international exposure?” Nazario said.

“If the goal is to maximize tax efficiency, discuss asset location with an advisor to explore if nontaxable entities are an appropriate vehicle to use for these investments,” he said. “Additionally, to maximize tax efficiency, investors may prefer investments that offer pass-through tax deductions, preferential tax treatment in terms of qualified dividends or long-term capital gains as opposed to ordinary income treatment and short-term capital gains.  While real estate has often provided many of these benefits, investors should evaluate every deal independently to understand the deal-specific tax implications.”

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