Pay Attention to Looming Changes in Your ‘Tax Alpha’

Editor’s note: This is the third of three blog posts to help you analyze the economic impact of the coronavirus pandemic on investments in opportunity zones such as our NEST Fund. Read the first post here and the second post here.

By Clint Edgington

Lost in the fog of the immediate pandemic crisis is the hangover impact of massive, new government borrowing and spending on tax policy.

That’s not just a question for wonks like me. Too many investors don’t consider tax impact on investment decisions. Any mutual-fund investor who has ever had an unpleasant, year-end surprise when their funds report gains from their activities would agree.

The current situation – in which government has dramatically increased its debt only a few years after doing the same thing via large tax cuts – will eventually force lawmakers to react beyond academic arguments about how much the federal deficit can grow before there’s a serious price to be paid. Remember: many of the lowered tax rates have sunset provisions. You can’t count on the current rates to continue indefinitely, and the odds of them going up are increasing.

The bottom line is that investors should be thinking, now, about finding tax-advantaged alternatives. Let me explain why that’s the case in more detail.

Government must finance its debt, just like everyone else. (The difference is that “everyone else,” including state and local governments, can’t print money to do so.) If the debt load becomes burdensome, financing costs increase.

The U.S. government collects tax revenue of about $3 trillion and spends about $4 trillion per year. That’s an average annual deficit just south of $1 trillion after the recent tax cuts. The supporters’ argument was that a growing economy would increase tax receipts in the long run, and also mean that the debt becomes a lower percentage of all economic activity – making it less worrisome.

Now that we’ve layered the coronavirus stimulus package of 2020 onto this, the deficit is ballooning in an economy that has distinctly slowed. If this continues, such debt levels simply aren’t sustainable. Even though politicians tend to focus on the short term and their re-election windows, which always makes cutting taxes attractive, it’s not realistic to count on taxes getting lower anytime soon. Mitch McConnell is one example from the Republican side who acted to halt federal coronavirus relief out of concern for debt, calling it “a matter of genuine concern.”

Unless Congress acts, income taxes will sunset back to the previous, higher income tax brackets in 2026. Now, let’s say our escape from this pandemic isn’t relatively swift. That boosts the odds of the Democratic Party, which opposed the recent tax cuts even before the pandemic, gaining power in the Senate, the White House or both in November. Even if the Republicans remain in power, the massive debt load will make any effort to keep current rates or even lower them extraordinarily difficult. (Remember, this used to be the political party that was most concerned about deficits.) Now lawmakers of both parties face a massive increase in debt load as well as the need to likely increase spending in public health and FEMA activities for the foreseeable future. Both parties already are discussing additional spending to help small businesses, the unemployed and others. That will mean even more debt.

Obviously, it’s always wise to look at tax consequences of investment decisions. With tax rates likely to increase, it’s even more important to do so.

At the simplest level that almost everyone can consider, this is a really good time to take maximum advantage of Roth IRAs. These are accounts in which you have already paid taxes on the invested dollars and all future gains are protected from further taxation. These are great vehicles for investment, whether you’re directly contributing to a qualified Roth or converting a tax-deferred IRA to a Roth. (Note that you will have to pay taxes when you convert the IRA funds.)

For investors with significant capital gains seeking a place to reinvest such funds, opportunity zones may make sense, as we have discussed in the two previous blog posts. The deadlines for investing in opportunity zones have also been relaxed as part of corona-related relief. Opportunity zone investments will defer taxation of gains and allow future gains to be tax-free in many cases. Our NEST Opportunity Fund focuses on residential real estate, generally the safest area for real estate investors and the area of real estate likeliest to be damaged the least once the pandemic slowdown ends.

The idea is to act now to protect your assets from future increases in tax rates. The bonus for doing so with these vehicles is that gains in those accounts also can be protected from future taxes, no matter what the rates.

We’re here to help guide you in these decisions. We invite you to contact us.

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Clint Edgington is co-founder of Nest Opportunity Fund and leads the investment team at Beacon Hill Investment Advisory. Beacon Hill provides advisory and family office services to business owners to simplify their financial lives, including their businesses, their retirement plans, and their public and private investment holdings.

Beacon Hill works with a business owner’s team of tax, M&A and legal professionals to evaluate and invest, in a tax-efficient manner, in private and direct investments – primarily focused on private debt, direct real estate, and small- to middle-market buyout and equity investments.

Clint has been admitted as an expert and testified before the National Association of Securities Dealers (NASD), New York Stock Exchange (NYSE) and Financial Industry Regulatory Authority (FINRA) on his analyses of portfolios and securities. He has also acted as trustee and administrator in a corporate role for 401(K)s, Profit Sharing Plans and defined benefit Pension Plans. As a plan fiduciary, he has managed brokers, evaluated the performance of money managers and managed other vendor relationships for ERISA-based plans.

He has been published or quoted in the Chicago Tribune, the Columbus Dispatch, the Journal of Financial Planning, Plan Sponsor Magazine, CNBC and other publications. In addition, he serves as the Chairman of the Columbus CFA Society Private Wealth Committee.

Clint graduated with a B.S. from Miami University with a major in Economics. He resides in Grandview Heights with his wife, Jenny and sons, Cole, Grant and Connor.

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Nest Opportunity Fund is an Opportunity Zone (OZ) investment program designed to not only do well for investors, but also do good for those in the communities targeted for fund investments. “Qualified Opportunity Zones” (OZs) were created by Congress in late 2017 with passage of the Tax Cuts and Jobs Act. This program offers deferral of initial capital gains tax owed, reduction of capital gains tax owed and elimination of capital gains on new investments. Our leadership team performed extensive research to select which type of under-invested Opportunity Zones will benefit from our engagement. We chose single-family homes and smaller multi-family homes because they present a lower risk to investors while maintaining the culture and character of the neighborhoods. We partner with thoroughly-vetted, regionally-respected contractors who specialize in managing multiple property upgrade projects at once. These homes are built to last, complete with solid wood cabinets, upgraded appliances, tankless water heaters and a catalog of other amenities to help improve the lives of residents and ease our management of them.