Private Credit Investing: Trends and Tax Strategies for High-Net-Worth Investors
In recent years, private credit has garnered significant attention among investors, with the sector surging from a valuation of $1 trillion in 2020 to an estimated $1.5 trillion by early 2024. This rapidly growing market is projected to reach $2.6 trillion by 2029, according to data from alternative investment research firm Preqin.
The Tax Implications of Private Credit Investments
While the allure of private credit investments is strong, they come with a critical downside: the returns generated from direct lending are subject to taxation as ordinary income, facing a top federal tax rate of 40.8%. This contrasts sharply with long-term capital gains, which are capped at rates up to 23.8%.
To illustrate the impact of this tax burden, consider a $5 million investment in private credit. Over a span of ten years, investors could realize a tax drag of approximately $4.3 million, escalating to around $61 million over 30 years, based on insights from Bernstein Private Wealth Management.
Mitigating Tax Liabilities
To counterbalance these hefty tax liabilities, investors have several avenues available. One common strategy is to utilize a Roth IRA, although these tax-advantaged accounts are often inaccessible to higher-income individuals. Consequently, many wealthy investors are shifting their focus to insurance products for more tax-efficient solutions.
Insurance-Linked Investment Strategies
Rather than investing directly in private credit funds, some are opting to buy insurance policies that allocate premiums into a diversified array of funds. Yasho Lahiri, a partner at the law firm Kramer Levin, notes, “You’re getting taxed on the insurance product, rather than being taxed on the underlying private credit investment.” This shift has catalyzed a rapid growth in insurance dedicated funds (IDFs), although the exact number of these funds remains uncertain, as many are unregistered.
IDFs must adhere to IRS diversification requirements, which can result in more modest returns compared to investing in a single high-performing fund. However, these funds also offer improved liquidity, a key advantage over traditional private credit investments.
Types of Investment in IDFs
There are primarily two approaches for investors wishing to capitalize on IDFs:
- Private Placement Variable Annuity (PPVA): This is typically the more cost-effective option and is suitable for clients holding investable assets between $5 million and $10 million. However, the income taxes related to these investments are deferred until withdrawals are initiated, potentially falling on either the policyholder or their beneficiaries.
- Private Placement Life Insurance (PPLI): This structure allows for tax-free transfer of benefits to beneficiaries upon the policyholder’s death, provided the policy is structured correctly. Despite the challenges of high upfront premiums and extensive underwriting, PPLI can be especially advantageous for those with investable assets exceeding $10 million.
Regulatory Considerations and Demand Trends
It’s important to note that both PPLI and PPVA are unregistered financial products, accessible exclusively to accredited investors—those with an annual income of at least $200,000 or a net worth exceeding $1 million—and qualified purchasers, who must possess a minimum of $5 million in investable assets. As inflation and stock market growth continue, these thresholds are becoming less prohibitive for potential investors.
The PPLI avenue has gained significant traction, having recently attracted scrutiny from Congress. An investigation by the Senate Committee on Finance described the PPLI sector as “at least a $40 billion tax shelter used exclusively by only a few thousand wealthy Americans.” Although proposed changes to curtail PPLI’s tax benefits were introduced, they are unlikely to advance in the current political climate.
Conclusion
As the demand for private credit and efficient tax strategies continues to rise among family offices and ultra-high-net-worth individuals, financial advisors are increasingly engaged in discussions surrounding these topics. With conventional tax-loss harvesting strategies already implemented by many, the focus is shifting towards innovative solutions that maximize after-tax returns in an evolving landscape of investment options.
