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You’ve probably heard this one before: it’s very important to perform the proper due diligence when considering any investment. Research any and all investments to evaluate their legality and potential for gain/loss.
But this becomes even more important for self-directed account holders. Because self-directed account holders choose to have more control of and responsibility for their investment assets, due diligence is key to helping prevent major issues with the investment. Such issues could include unwanted tax ramifications, account disqualification, or even legal consequences.
It helps to ask your investment advisor these eight questions, among others, when considering an alternative investment.
- What is the total cost? Of course, the purchase price of the asset is important, but so too are advisor fees and any processing or custody fee. These can eat away at your potential returns if you’re not careful. This is also the point where you find out how the advisor receives payment for the purchase, which will be important when considering future transactions and avoiding conflicts of interest. Also, will the advisor need to seek out other experts for certain investment-related services?
- How often will we discuss the investment? How much access will you have to the advisor? You likely won’t want an investment advisor who only engages with you upon an annual account checkup. It’s best to know right out of the gate if he or she will stick closely to a schedule or will allow deviation. You may prefer an advisor with an “open door” policy, able to meet with you as frequently as you wish.
- What is your experience with this type of investment? This one is extremely important (not that any of the others aren’t, of course). While it may sound like common sense, you will want to work with someone well-versed in the asset type. In fact, you will need to confirm the advisory firm will even allow the investment on its platform. If not, you will likely have to go elsewhere.
- Who is your custodian? This one goes along with the previous question, because if the answer doesn’t reveal a custodian well-versed in the custody of that type of asset, then (once again) you will likely have to go elsewhere. Additionally, most alternative asset investors prefer advisors who work with an independent custodian than those that provide custody themselves.
- Will the investment violate prohibited investment or prohibited transaction rules? Failure to follow prohibited investment and prohibited transaction rules may result in account disqualification. For example, there are three types of investments you cannot invest in using IRA funds. In addition, a prohibited transaction inside a retirement account could mean the entire amount is distributed to you. This may result in taxes owed on the full amount if in a Traditional IRA or similarly-structured account. Ensure your investment can be held in a retirement plan and isn’t related to any disqualified individual or entity.
- What tax ramifications will I have to deal with? This ultimately depends on the asset. Nonetheless, it’s important to have the discussion with your investment advisor as soon as possible. For instance, if your account uses borrowed money to acquire an asset, the account may earn unrelated debt-financed income (UDFI). You might have to pay taxes on income related to the borrowed money, even if it’s inside a retirement plan. Also, if your investment will be in an entity producing unrelated business taxable income (UBTI), your account may be subject to tax (UBIT) pursuant to IRC Section 511. This generally involves limited partnerships, limited liability companies, and other investments incurring debt financing like leveraged real estate. Ultimately, this question keeps tax ramifications top-of-mind for your investment advisor. Even if he or she is unable to answer them and directs you to a tax professional, your advisor is at least aware that those are considerations that will affect your investment decisions.
- Will the investment need more money down the road? Is this a type of investment requiring funding “down the road” beyond your initial purchase amount? Your advisor must help you determine if you can maintain the investment if additional capital is needed.
- When will I begin to see a return on my investment? Ensure the rate of return and timetable agree with your long-term goals. Also, if held inside an IRA, consider your retirement income needs and any distribution rules you must follow. An investment taking many years to bear fruit may not mesh with your ultimate investment expectations.
It’s best to discuss these questions with your investment advisor before making an investment in alternative assets.
Also, don’t take the advisor’s answers at face value. Ultimately, you should perform the proper research on all parties involved to ensure they’re right for you. It’s also best to include your entire team of professionals during the process.
Note: this is merely a partial list, as you should bring a wealth of questions to any investment-related discussion. To be fully educated about any potential investment, perform a thorough investigation before you invest.
Wondering if Kingdom Trust can hold your potential investment on our platform? You can learn much more about the alternatives we custody by exploring our website. Also feel free to chat with us, email Client Services, or give us a call at 888.753.6972.