There are thousands of investment opportunities being marketed in the United States offering the allure of significant tax savings. Some offer a potential deduction against ordinary income, such as an investment in oil and gas exploration or an investment in exotic wildlife breeding. Municipal bond investments may avoid federal, state and local ordinary income tax depending on the residence of the investor. Other investments offer the potential to defer capital gains taxes. Many have heard of a Section 1031 exchange transaction in which capital gains taxes on appreciated real estate are deferred upon sale if the proceeds are invested in another qualifying real estate investment. This concept has been expanded through Delaware Statutory Trust (DST) offerings. A DST allows an owner of appreciated investment real estate to invest sale proceeds into a real estate fund managed by a sponsor. This may be appealing to someone who no longer wants to actively manage a real estate investment. Some sponsors combine a DST with a Section 721 UPREIT transaction that may allow the proceeds from a real estate sale to be converted to shares of a publicly traded Real Estate Investment Trust (REIT). While 1031, DST and 721 products may defer capital gains taxes from investment real estate, a Qualified Opportunity Zone fund may defer capital gains taxes on a much broader range of appreciated assets including the sale of stock, bonds, businesses, collectibles or real estate that would not qualify for a 1031 exchange.
While the potential for tax savings is enticing, these investments are not for everyone and often carry a high degree of risk. I have compiled several considerations to help evaluate if an investment offering may be appropriate for you.
- Structure: These investments are often complex and there are rules that must be met for the potential tax savings to apply. A thorough understanding is crucial.
- Eligibility: Because of the risk and complexity, these investments are typically only available to those who are deemed to be an accredited investor or a qualified client based on levels of sophistication, assets, or income.
- Fees: The fees can be higher than some investors have come to expect and there may be multiple layers of fees.
- Illiquidity: You may not have access to your funds for a prolonged period of time or may have limited rights of redemption (potentially with a penalty). You should understand the anticipated length of the fund and redemption rights.
- Suitability: What percentage of your portfolio should be allocated to private investments based on factors such as your risk profile, age, and liquidity needs? You should also consider the concentration of asset classes in your portfolio.
- Sponsor: Not all sponsors are alike. You must understand the background, experience, and track record of the sponsor and its principals.
- Investment: You should evaluate the strength of the underlying investment. You may have potential tax savings by investing in the redevelopment of a brownfield in a qualified opportunity zone. However, if the redevelopment fails, the loss of your principal will likely far outweigh any potential tax savings.
- Risks: A private placement memorandum should outline the potential foreseeable risks.
- Transferability/Death: Can the investment be gifted or transferred and what are the consequences of doing so? You must also understand what happens if you should pass away prior to the conclusion of the investment.
- IRA: Some investment funds allow investment through IRA or other tax deferred accounts. You must understand the consequences of making an investment through an IRA, including the potential for the loss of tax savings as well as Unrelated Business Income Tax (UBIT).
- Tax Savings: Based on the projected investment returns and potential tax savings, would you be better off in a less expensive, less risky, and more liquid investment?
A member of the EBS Wealth Management team can help you evaluate whether a potential investment opportunity may or may not fit within your broader financial plan.
Disclosure – The information presented is for educational purposes only and should not be construed as an investment recommendation or solicitation of any particular security, strategy or investment. Past performance is not indicative of future results, and all investments involve risk, including the potential loss of principal. The information provided is from sources believed to be reliable, but its accuracy is not guaranteed. Tax treatment is subject to change and depends on individual circumstances. Investors are encouraged to consider their financial situation and consult with their financial and tax advisors before making investment decisions.