Beware of Headaches from Exotic Investments

Article: Are Exotic Investments Worth the Headaches?

If you’re considering an exotic investment, be prepared for the potential side effects – including tax problems, stress, and financial loss.

by Jean-Luc Bourdon, CPA/PFS

Non-traditional investments can seem exotic and cutting-edge, and many investors are lured by the promise of attractive returns. However, they don’t always realize the potential legal, financial, and tax risks associated with such investments.

Investors are often attracted to non-traditional investments because they seem exclusive and prestigious. Hedge funds, for example, are often marketed to wealthy investors as a way to gain access to sophisticated investment strategies and exclusive investment opportunities. But the allure of exclusivity can blind investors to the legal and financial risks involved.

Of course, investing always carries inherent risks. However, non-traditional investments like cryptocurrency, partnerships, and investments for qualified investors often come with greater legal risks and higher tax-compliance costs than well-regulated investments, like stocks and bonds traded on major exchanges such as the NYSE, that most investors are accustomed to.

Unfortunately, too often, investors find out the tax implications of complex investments when they file their tax returns. Or they may find the regulatory and legal implications when something goes wrong, and they realize they must seek redress on their own through the court system. The regulatory cavalry may not come to the rescue.

Non-traditional investing can also be compared to driving on a state-maintained road. Inside a well-regulated framework, it is like driving on a smooth, well-maintained pavement with clear directions and signs. In contrast, going off-road outside that framework is more challenging, with rough terrain, and no signs. And if anything breaks down, it’s more difficult to get anyone to help.

In addition to risks, non-traditional investments may also involve complex tax compliance. Investors in partnerships and certain types of financial entities, for example, are required to file a form K-1 to report their share of the income, deductions, and credits of the entity. This can be a time-consuming process, and investors may have to wait for Form K-1 to arrive before they can file their personal tax returns. This delay can force investors to file for a tax extension and estimate their tax liability payment, which complicates the filing of their tax returns.

The complexity of tax compliance is compounded for investments that involve depletion, international reporting, or other intricate tax issues. For example, investing internationally involves a number of considerations and possible reporting requirements. The expertise needed to evaluate them can be expensive. The penalties for failing to meet those requirements can be steep.

Given these potential risks and challenges, it is essential for investors to carefully evaluate any non-traditionally regulated investment opportunities before making a decision. They should also work closely with specialized financial professionals who have experience navigating the relevant regulatory and tax landscapes.

Financial advisors often focus on risk tolerance, and their clients are generally familiar with risk questionnaires. In addition, it would also be wise to consider complexity tolerance and cost tolerance. It’s not uncommon for investors to develop resentment for difficulties and compliance costs. For example, on more than one occasion, I’ve been asked for my opinion on investing in a directly owned rental property. It depends, of course, so I start by asking: Do you want to be a landlord? Several times, clients then immediately abandoned the idea once the potential headaches came to mind.

Here’s a fascinating catch-22: when you don’t have a lot of money to invest, complex investments may not be worthwhile, because their costs could eat too much of the possible returns. But when you do have a lot of money to invest, you don’t need to complicate your life with them. Therefore, people looking at fancy investments are often motivated by more than just potential returns – in the same way that the motivation to purchase a Rolex wristwatch isn’t solely related to timekeeping.

Ultimately, while these investments can offer attractive returns, they may also come with significant legal, financial, and tax risks. So investors should carefully weigh these risks against potential rewards before deciding to invest in non-traditionally regulated investments. By doing so, they can make informed investment decisions that align with their financial goals and tolerance for risk, complexity, and compliance costs. Benjamin Franklin said: “An ounce of prevention is worth a pound of cure.” Indeed, a thorough investment diagnostic is a potent way to avoid headaches.

About the author: Jean-Luc Bourdon, CPA/PFS

Jean-Luc Bourdon, CPA/PFS Jean-Luc Bourdon is the founder of Lucent Wealth Planning, a wealth management firm located in Santa Barbara, California. He previously developed a Registered Investment Adviser (RIA) entity for a CPA firm. In the past, Jean-Luc served on the PFS Credential Committee and on the Personal Financial Planning Executive Committee of the AICPA. He has written many financial planning articles for AICPA publications including the Journal of Accountancy, the Tax Adviser, CPA Insider, and Wealth Management Insider. Jean-Luc received the 2017 Personal Financial Planning Distinguished Service Award from the AICPA. He served for a decade on the Personal Financial Planning Committee of the California Society of CPAs.

This article (and video) is for general information and educational purposes only and is not intended to serve as specific financial, accounting, legal, or tax advice. Individuals should speak with qualified professionals based on their circumstances. The analysis contained in this article may be based upon third-party information and may become outdated or otherwise superseded without notice. As the old adage goes, an ounce of prevention is worth a pound of the cure. Considering all aspects before investing is a potent way to avoid headaches.