The Tax Implications of Angel Investing
Regardless of whether your angel investment generates a loss or a solid return, there are tax implications you should know about. Blake Christian, CPA, a tax partner at HCVT in Long Beach, California, and an angel investor himself, explains.
Tidal River: Hi, Blake. Thanks for sharing your expertise with our network. First question: If an angel investor loses money on a deal, can she always write it off?
Blake Christian: She will always generate a loss, generally a capital loss, which can offset her capital gains dollar-for-dollar or be used to offset other income at the rate of $3,000 per year.
TR: Sounds simple enough. Is there anything else investors should know about the tax implications of losing money on an angel investment?
BC: Yes. If the promotor follows certain rules and the investment is under $50,000 for a single filer or $100,000 for joint, the taxpayer can claim an ordinary loss up to those limits upon disposition.
TR: What about the angel investor who beats the odds and gets a large return? She would pay capital gains, correct?
BC: She should first check if IRC Section 1202 applies—generally a non-service business operated as a C Corporation for at least five years. If not, and if the gain is significant to the taxpayer, she could consider rolling the gain into a captive or third-party, meaning public, qualified opportunity fund. Interested readers can learn more here.
TR: Section 1202 of the tax code allows angel investing to create especially attractive types of capital gains. Can you explain what this means?
BC: For patient investors operating in the right industry—most service industries don’t qualify—the sale of a C Corporation equity interest operating as a C Corporation for at least five years can generate tax-free gains up to the greater of $10 million per investor or 10 times the investor’s tax basis in their capital investment. The investor can also elect to roll the gain into another equity investment within 60 days. If you’re interested in learning more about both 1202 and opportunity zones, click here.
TR: Can you tell us a little more about deferring gains through the opportunity zone program? Is that something any investor can do?
BC: Billions of dollars are going into the program monthly, and taxpayers can defer gains until 2027—assuming they reinvest in a timely manner and hold the investment for at least 10 years—and all appreciation in the fund escapes federal, and most state, taxation. All depreciation claimed also avoids traditional “recapture” upon sale. Any taxpayer with a short- or long-term gain is potentially eligible to participate. Most of our clients set up their own “captive” opportunity zone funds and then invest in their own real estate projects. Alternatively, they can start an operating business, purchase a business, or move a business into any one of 8,700 opportunity zone census tracts, characterized by low income and high unemployment.
TR: Definitely something to think about. When it comes to angel investing, is there a tax advantage to investing a small amount in a number of companies, or a large amount in one company?
BC: Diversity is always a smart investment strategy, but I generally recommend investing with known management teams and businesses that the investor understands.
TR: As a seasoned angel investor yourself, what are some lessons you’ve learned along the way?
BC: No matter how great a business plan sounds, expect numerous business challenges. And make sure you relay your expectations on financial reporting timelines and operational updates; communication is key. Also make sure you understand any exposure to company liabilities and whether you have any “capital call” requirements.
TR: Any industries you’re excited about investing in right now?
BC: I am biased, but I’m currently focused on affordable housing, including homeless, workforce, temporary and emergency housing, through my OZ fund, which you can learn more about here.
TR: Connecticut has an Angel Tax Investor program, which provides qualified investors with a 25 percent credit against the state income tax when the angel invests at least $25,000 in a qualifying business. Do other states have similar programs? Is there a database of these types of programs?
BC: There’s no master database, but I know that Ohio has a 10 percent opportunity zone fund credit for investing in Ohio opportunity zone projects.
TR: Any other advice you would like to share with novice angel investors, tax or otherwise?
BC: Generally, invest in minimum tranches on any startup and then invest more once you are more comfortable. In today’s high interest rate environment, you can get some healthy returns off of loans, so consider structuring convertible debt deals. Even though you do not generally get capital gains treatment on debt, if you do not get paid back and have a history of making loans, it’s easier to get ordinary losses and you can claim partially worthless bad debts, whereas claiming worthless securities deductions is very difficult. Anyone who is interested in learning more can do so here.
TR: Thanks for your time, Blake. Great information.
BC: My pleasure.
(***Disclaimer: The information from this interview should not be taken as tax advice. Investors should consult their own tax professional regarding any tax-related questions.)