Navigating taxes on alternative investments and partnerships

If you're an investor looking to diversify and grow your portfolio, you might consider investment partnerships — also known as "alternative investments" or "alts." These allow qualified investors to put money into harder-to-access assets like private equity, venture capital, private loans, real estate and even some publicly traded stocks.

In the past, only very wealthy investors could get into these opportunities. But now, many investment partnerships are more accessible and offer more flexible terms.

How investment partnerships work

When you invest in a partnership, you usually commit a certain amount of money (say, $500,000), which is gradually "called" or used over time — often over two to three years. Any profits or returns are paid out over time as well, and full liquidating payouts can take up to 10 or 12 years. These investments are long-term and not easy to cash out early, but that lack of flexibility often means you may be able to earn higher returns.

Understanding the taxes

As an investor, you become a limited partner. Each year, you'll receive a form K-1, which reports your share of the partnership’s profits, losses, investment income and expenses. These forms typically come out later in the year — often in August or September — so you may need to file an extension for your personal taxes until October 15.

Gifting your investment

Since these investments are hard to sell quickly, some investors choose to gift them to a family member, friend or trust. This requires approval from the partnership sponsor. Plus, the recipient may need to meet the same investment qualifications that you originally met. The gift keeps your original cost basis, meaning the new owner takes on your original investment value for tax purposes. Because the investment isn’t easy to sell, the gift might be valued at a discount (often 20–30%), and an appraisal is needed.

What happens after death?

If you die owning a partnership interest, your investment’s value usually gets updated to the fair market value on your date of death. But partnerships have two types of value: your outside basis (your investment value) and the inside basis (the partnership's internal value).

Unless the partnership files a special tax election (called a §754 election), only the outside basis gets updated. The inside value will stay the same, which can create tax issues for your heirs.

• Example:
  • You invested $500,000 and it’s now worth $600,000.
  • At your death, the outside basis gets stepped up to $600,000. The inside basis is still $500,000 unless the partnership makes a special election, which they rarely if ever do. 
  • If your heir later receives a liquidating distribution of $600,000, they won’t owe tax. But the partnership will still report a gain of $100,000 on the inside basis, so it is up to your heir or their tax preparer to track the adjustment to cost basis. 
  • But if your heir only gets $500,000, they could claim a $100,000 loss. But again, they need to track the adjustment to outside basis. 
  • If the partnership distributes property valued at $600,000, the basis of that property will also be $600,000.

Your heir’s updated outside basis can help reduce future taxes, but only at the final liquidation of the partnership.

Problems arise before liquidation, if the partnership sells assets with low inside basis or distributes appreciated property—this can cause unexpected taxes as the tax on gains will need to be paid.

Because of these complexities, the estate of a deceased owner often needs to stay open until the investment ends. Heirs who receive a partnership interest need to track values carefully to take advantage of possible losses or a step-up in cost basis.

Plan ahead

Investment partnerships require careful tax planning. It can be advantageous to invest through a revocable trust or an LLC to simplify future transfers and reduce estate-related fees. If you’re investing significant amounts, working with a professional tax and legal team is highly recommended.

Our advisors are always available to evaluate your circumstances and the options that may make the most sense for you and your family.