Alternative investments provide a dynamic way for participants to diversify portfolios and potentially enhance overall returns. By definition, an alternative investment “is a financial asset that does not fit into the conventional equity/income/cash categories” and may include:
- Private equity or venture capital
- Private credit
- Cryptocurrency
- Hedge funds
- Real estate
- Infrastructure
- Commodities and natural resources
- Collectibles
Many of these assets deliver extensive opportunities for higher yields and a lower correlation with traditional markets, making them a popular option for diversifying portfolios, building wealth and retirement planning. Recent statistics on alternative assets reveal that alternative investment assets under management totaled $13.7 trillion in 2021 — a number that’s projected to reach $23.3 trillion by 2027.
Alternative investment vehicles may offer users extensive benefits and unique opportunities when included in cohesive investment strategies and retirement planning. While there’s no such thing as risk-free investment strategies, nontraditional assets can potentially:
Reduce Portfolio Volatility
Alternative investments can help reduce overall portfolio risk and volatility by being low-correlated with traditional asset classes like stocks and bonds.
Increase Potential for Higher Returns
Beyond external marketplace resilience, many nontraditional assets have the potential to outperform traditional market investments for increased ROI when managed effectively.
Provide Access to Unique Investment Opportunities
Alternative investments provide access to unique markets and investment opportunities, such as art, wine, and collectibles, and even niche sectors, such as renewable energy projects. These opportunities enable investors to customize their portfolios based on personal preferences, lifestyles, and passions.
Additionally, some alternative investments, such as commodities and real estate, can serve as effective hedges against inflation. As prices rise, the value of these physical assets tends to increase, helping to preserve purchasing power. This type of marketplace resilience makes these assets attractive for investors looking to protect their portfolios from inflationary pressures.
Common Tax Challenges: Issues Investors Face
Of course, as with all investment strategies, the potential for reduced portfolio volatility and outsized gains can bring additional tax consequences and considerations. Nontraditional assets often have unclear rules and reporting requirements that may confuse even the most savvy investors. Some of the most common challenges investors face with tax compliance on alternative assets include:
Complex Tax Structures
Unlike traditional investments, alternative assets often involve intricate tax structures that require careful management.
Unpredictable Income Streams
The income generated from alternative investments can be irregular and unpredictable, complicating tax planning.
Regulatory Changes
Tax laws regarding alternative investments can change frequently, requiring investors to stay informed and adapt quickly.
Record-Keeping Requirements
Detailed and accurate record-keeping is essential but can be cumbersome, especially with diversified portfolios.
These often unclear and ever-evolving tax compliance mandates can come at a cost for investors, including nontraditional assets in their portfolios. Failing to understand and adequately report alternative investment income can lead to hefty penalties and fines.
Solutions and Strategies: How to Invest Without Tax Headaches
Navigating the complex tax landscape with alternative investments can be challenging. However, developing specific strategies to streamline the tax compliance process is possible. By proactively addressing tax implications, investors can maximize the benefits of alternative assets while minimizing unnecessary penalties and fines. Some components to consider in a cohesive strategy include:
Consult a Tax Planning Professional
Working with a tax planning or financial professional is a critical first step in developing investment strategies that optimize returns and uphold compliance. Work with a professional team that specializes in alternative investments to ensure they are well-versed in the nuances of various asset classes. Getting professional input can help you develop a plan uniquely suited to your financial goals and navigate all compliance requirements. Most importantly, tax and financial professionals make it their mission to stay on top of ever-changing legislation to keep you up-to-date with the latest developments.
Utilize Tax-Advantaged Accounts
Investing through tax-advantaged accounts, such as IRAs or 401(k)s, can defer or minimize taxes on your investments. For example, a self-directed IRA allows you to include alternative assets like real estate and private equity in your retirement portfolio. This can defer taxes on income and capital gains until retirement, maximizing the growth potential of your investments.
Diversify Across Tax Treatments
Spreading investments across assets with different tax treatments can help balance taxable income and capital gains. For instance, combining tax-deferred investments like real estate with more liquid, taxable assets can optimize your overall tax strategy. This approach can provide more stability and predictability in your tax planning.
Leverage Tax-Loss Harvesting
Tax-loss harvesting involves selling underperforming assets to offset gains from other investments, reducing your overall tax liability. This strategy is particularly effective in volatile markets, such as those for cryptocurrencies or emerging market funds. By strategically timing your sales, you can take advantage of losses to minimize your tax burden.
Best Practices for Tax-Efficient Investing in Alternatives
Of course, creating a plan is only the first step to avoiding tax headaches. Investors must also consistently put the plan into practice. To ensure your alternative assets follow a tax-efficient investing strategy, consider adopting the following best practices:
Detailed Record-Keeping
Maintain meticulous records of all transactions, income, and expenses related to your alternative investments. This includes keeping receipts, contracts, and correspondence that can support your tax filings. Accurate record-keeping ensures compliance and helps you make informed decisions about your investments.
Strategic Asset Allocation
Allocate assets to align with your overall financial goals and tax strategy. For example, placing income-generating assets in tax-deferred accounts and high-growth holdings in taxable accounts can optimize tax efficiency. This approach can help you manage your tax liability while still achieving your investment objectives.
Regular Reviews and Adjustments
Periodically review your investment portfolio and tax strategy to ensure they remain aligned with your goals and the current tax landscape. Life events, market changes, and legislative updates can all impact your tax planning. By regularly reassessing your strategy, you can make necessary adjustments to stay on track.
Risk Management
Diversify your alternative investments to spread risk and avoid over-concentration in any single asset class. This protects your portfolio from market volatility and helps manage your tax exposure. A well-diversified portfolio can provide more consistent returns and reduce the likelihood of large, unexpected tax consequences.
Schedule an Appointment With Our Financial Planning Professionals
Navigating tax compliance for alternative investments can seem daunting. However, you don’t have to go it alone. Destiny Capital’s team of financial, and retirement planning professionals can help you develop a customized plan that aligns with your investment goals, risk tolerance, and tax obligations. Schedule a consultation today to learn more.
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DISCLOSURE: Tim Doyle is an officer of Destiny Capital and Entrepreneur Aligned, a DBA of Destiny Capital. This article is for informational purposes only and should not be relied upon as a basis for your investment, business, or personal financial decisions. We recommend consulting with your wealth advisor, CPA/tax advisor and/or attorney, as applicable to your situation, prior to implementing any new tax, legal, or investment strategy. Advisory services offered through Destiny Capital Corporation, an Investment Adviser registered with the U.S. Securities & Exchange Commission.