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Financial Planning > Tax Planning

3 Tax-Friendly Investments for Wealthy Clients

By Roger Wohlner

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What You Need to Know

  • Qualified opportunity funds offer a way to defer capital gains from other investments.
  • Qualified small business stock offers a tax-advantaged way to invest in small company shares.
  • An exchange fund offers some investors an option to diversify their concentrated positions.

There are a number of tax-friendly investment options that could benefit high-net-worth clients looking to manage their taxes. Three examples are qualified opportunity funds, qualified small business stock and exchange funds. 

These can be good options for some clients in certain situations, offering solid tax advantages, but there are also risks.  

Qualified Opportunity Funds

Opportunity zones were created by the Tax Cuts and Jobs Act of 2017 to encourage investment in low-income areas. According to the Internal Revenue Service, thousands of low-income communities in all 50 states, the District of Columbia and five U.S territories are designated as opportunity zones. 

Congress created qualified opportunity funds (QOFs) to facilitate investment in these areas. A QOF is not a mutual fund but rather a corporation or partnership that is formed for the purpose of investing in property in a qualified opportunity zone. In fact, 90% of the money in a QOF is required to be invested in qualified opportunity zone property. 

Benefits of QOFs

Some pros of qualified opportunity funds for clients include: 

  • The ability to defer taxes on realized capital gains from other investments into a QOF within 180 days of realizing the gain. The gain can be deferred until the earlier of when the qualified opportunity fund is sold or exchanged or Dec. 31, 2026. Note that investors can use only the gain portion of this prior investment to fund the QOF while “pocketing” their cost basis from the prior investment tax-free to use as they wish.
  • If investors hold their investment in a QOF for at least 10 years, the appreciation on the money used to invest in the fund will not be subject to capital gains taxes. Note that they will be subject to capital gains taxes on any funds invested that used the tax deferral once the Dec. 31, 2026, date has passed. Any appreciation from the money invested in the qualified opportunity fund will retain its eliminated status if the QOF is held for at least 10 years. 

Clients who invested early in a qualified opportunity fund using realized capital gains from other investments had the opportunity for a 10% step-up in basis if the gains were held in the fund for at least five years and an additional 5% step-up for funds held at least seven years. The step-up expires on Dec. 31, 2026, so the initial investment period for this benefit has lapsed.  

Drawbacks of QOFs

Some potential pitfalls of qualified opportunity funds include: 

  • Investors must be accredited investors to be able to invest in many QOFs.
  • Investing in an opportunity zone can provide benefits to the community involved, but the benefits for those investing in these areas through QOFs are still unclear.
  • It is important for prospective investors to do their due diligence as to where the qualified opportunity fund will invest and the viability of these investments. It is also critical to research the background of those managing the fund to determine their qualifications and any past successes for investors.
  • Not all states follow the federal rules regarding tax benefits at the state level. 

Qualified opportunity funds offer an opportunity to invest in lower-income areas or opportunity zones. The jury is still out on whether these are good investments. QOFs offer a number of tax advantages, but each fund needs to be scrutinized before a client invests.

Qualified Small Business Stock

Qualified small business stock (QSBS) allows shareholders of certain small businesses to be excluded from federal taxes on any gains from selling the shares. This falls under Section 1202 of the IRS code. 

Section 1202 provides an incentive for individual, non-corporate investors to invest in the shares of small businesses. The latest iteration of Section 1202 says that 100% of any capital gains of shares acquired after Sept. 27, 2010, will be excluded from taxes if the shares are held for at least five years. Additionally, the alternative minimum tax will not apply to shares sold, nor will the 3.8% net investment income tax assessed to high-income taxpayers as part of their capital gains taxes.

Shares acquired before Sept. 27, 2010, are eligible for lesser capital gains exclusions and are not exempt from the AMT.

The main benefit of investing in qualified small business stock is the potential for federally tax-free capital gains if the shares perform well. This capital gains tax exclusion can greatly increase clients’ profits on holding the shares if things pan out well for them.  

If a client is fortunate enough to invest in a small business that makes it big and whose shares really appreciate, this can help build wealth. 

QSBS Rules and Restrictions

However, there are a number of rules and restrictions to be aware of. In order to qualify for this exemption, investors must meet a number of requirements including: 

  • Shareholders cannot be other corporations. Individuals, trusts and some pass-through entities qualify as eligible shareholders.
  • The holding period requirements can cause clients to hold the shares longer than they might otherwise do in the event the company’s shares skyrocket in value early on. Holding for the tax benefits might cause them to lose some appreciation if the shares ultimately decline after some early gains. 
  • The shares must have been issued by a domestic C-corporation that is not a hotel, restaurant, financial institution, real estate company, mining company or a business involved in law, engineering or architecture.
  • The shares must have been issued after Aug. 10, 1993, in exchange for money or property, not for stock or as compensation for services rendered to the company.
  • As of the date of the stock issuance, the company must have at least $50 million in assets.

Additionally, small companies can be risky. While there are notable small companies like Apple that made it big, that is not always the case. Clients must weigh the risks of investing in a small company against the potential gains. 

It’s important to stress both the potential risks and rewards and to help ensure that clients do not over-invest in any single small company. 

Exchange Funds

Exchange funds, also known as swap funds, are private funds designed as a solution for investors with concentrated stock positions. They are typically created by a large bank, an investment company or other financial institution. 

Exchange funds offer the option for investors with a concentrated position to exchange their shares for shares of the fund. This could include clients with concentrated positions in their company shares due to receiving stock compensation from their employer, allowing them to defer any capital gains on the shares swapped into the fund. Any capital gains will then be paid on shares of the exchange fund, if applicable, when these shares are sold. 

Exchange funds can invest up to 80% of their assets in stocks and bonds that trade on public exchanges, while at least 20% of the fund’s assets must be invested in qualifying assets such as real estate holdings. 

Typically, an exchange fund might invest in a portfolio with similar holdings to a major index like the S&P 500. There are also private exchange funds that allow investors to diversify concentrated private-equity holdings. 

Exchange Fund Benefits

Potential pros of an exchange fund include: 

  • The ability to diversify a client’s concentrated position without triggering current tax consequences.  
  • The ability to invest in a professionally managed, diversified portfolio.
  • The potential for higher returns since the full amount of a concentrated position is invested with no current tax reduction. 
  • Under current rules in the event of a client’s death, heirs would receive the shares with a step-up in basis. 

Exchange Fund Drawbacks

Potential cons of an exchange fund include:

  • In some cases, investors in an exchange fund may be required to be an accredited investor or a qualified purchaser.
  • While swapping some or all of a client’s shares in a concentrated position for a more diversified portfolio can have advantages in terms of diversification, it may carry an opportunity cost if the concentrated shares end up outperforming the exchange fund portfolio.
  • Liquidity restrictions. Exchange funds typically require investors to hold the shares for at least seven years. Early redemptions are subject to penalties and may include shares of the stock originally contributed to the fund. 
  • There could be risks associated with the real estate component of the fund in certain market environments. 
  • Some exchange funds have high fees and expenses.

There are certainly pros and cons associated with an exchange fund, and these need to be weighed against each other before advising a client with a concentrated position to invest here. 

Conclusion 

Qualified opportunity funds, qualified small business stock and exchange funds all offer certain tax advantages to investors and may be appropriate for some clients. 

Depending upon a client’s situation, there may be other options to defer or offset taxes on certain investments. A 1031 exchange can be a good solution for real estate, a 1045 for qualified small business stock, and an installment sale or a variety of charitable strategies. 

Clients, with individual situations, depend on financial experts to find the right strategies to help them invest as tax-efficiently as possible while minimizing their risk. 

Roger Wohlner

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