Key Takeaways:

• Under current tax rules, hedge funds can’t usually deduct costs unless they are classified as trader funds. The TCJA suspended these deductions through 2025, but post-2025 treatment will depend on future legislation.
• Hedge fund managers must hold investments for three years to receive preferential capital gains tax treatment on carried interest.
• Schedule K-1 delays and international investment filings should be expected by investors.

While hedge funds offer strong returns, recent tax law updates have added complexity. Strategic investing requires a clear understanding of these changes. This overview explores the benefits, complications, and key tax issues affecting hedge funds through 2025 and beyond.

What is a Hedge Fund?

Hedge funds are investment pools structured as pass-through entities, primarily accessible to accredited investors, such as high-net-worth individuals and institutions. A hedge fund lacks a legal definition; however, most exhibit the following characteristics:

• A variety of investment strategies, including stocks, bonds, derivatives, and private equity.
• Performance-based manager pay (carried interest).
• Leverage is utilized frequently to increase returns.
• Pass-through taxation requires investors to receive an annual Schedule K-1.

Understanding the above characteristics will help investors decide if hedge funds fit their financial goals.

Benefits of Hedge Funds

Trader and Investor Funds

Trader and investor hedge funds have different tax effects. Trader funds emphasize frequent short-term trading and allow investors to fully deduct ordinary and necessary business expenses, helping reduce their taxable income. Conversely, investor funds generally pursue a more passive, long-term investment approach.

The Tax Cuts and Jobs Act (TCJA) suspends miscellaneous itemized deductions, including fund-related expenditures from investor money, through 2025. As a result, individual investors cannot currently deduct these fees, making trader funds more tax-efficient during this period, according to the IRS.

Non-passive Income

Another important advantage for investors in trader hedge funds relates to how fund losses are classified. Because these losses are treated as ordinary losses, high-net-worth individuals can use them to offset other active income, such as salaries or business earnings, providing meaningful tax flexibility.

This treatment offers significant tax relief for high-net-worth individuals with active income, allowing them to strategically reduce liabilities and improve overall investment returns (IRS Publication 925).

Understanding distinctions between trader and investor hedge funds is critical to maximizing your tax advantages. Investors should consider these classifications carefully to align hedge fund selections with their broader financial and tax planning strategies.

Complications of Hedge Funds

Delayed K-1 Forms

Hedge funds commonly issue Schedule K-1 forms well after April 15, often requiring investors to file extensions for their tax returns. Calculating and reporting each investor’s income, deductions, and credits is complicated, causing delays.

Compliance timelines have been extended due to the implementation of Schedules K-2 and K-3, which aim to improve transparency around international tax matters, such as foreign income and credits. These forms primarily affect partnerships with foreign investments, increasing the complexity of filing. This is especially true for investors with foreign holdings, who may face added reporting challenges.

Proactive communication with fund managers can help set expectations and reduce stress during the K-1 and K-2/K-3 filing season.

Foreign Investment Reporting

Investing in hedge funds with international or offshore operations may result in increased regulatory reporting requirements, complicating tax obligations for investors.

Common reporting forms are the Report of Foreign Bank and Financial Accounts (FBAR) and the Foreign Account Tax Compliance Act (FATCA) Form 8938. The forms necessitate the disclosure of foreign financial assets and accounts, with defined thresholds that trigger reporting obligations.  Inaccurate or late filing of these forms may result in significant penalties, beginning at $10,000 per violation under FBAR and reaching up to $50,000 for ongoing non-compliance with FATCA (Form 8938).

Given the significant penalties involved, investors should collaborate closely with international tax compliance specialists to complete all responsibilities and avoid severe penalties. Hedge fund investors should ask about potential foreign exposures in their funds’ portfolios to comply with IRS Foreign Assets reporting requirements.

Tax Issues Regarding Hedge Fund Investments

Investing in hedge funds can offer attractive returns; however, the tax implications are complex. A brief overview of essential considerations for investors and fund managers is provided below:

• Carried Interest: Hedge fund managers must meet a three-year holding period to qualify for long-term capital gains treatment on carried interest. If this period isn’t met, the income is taxed as short-term gain and subject to ordinary income rates—up to 37%, per IRS Section 1061.
• Investment Interest Expense: Investment interest can only be deducted against net investment income. Any unused amounts may be carried forward indefinitely. Recent IRS guidance clarifies that passive investors are also eligible for this treatment, helping prevent overlapping limitations.
• Capital Gains Taxes:
  • Short-term gains (assets held <1 year) are subject to ordinary income tax rates, which may reach up to 37%.
  • Long-term gains (held >1 year) enjoy reduced rates of 15% or 20%, depending on income level.
• Unrelated Business Taxable Income (UBTI) for Tax-Exempt Investors: Tax-exempt entities, such as retirement accounts, may incur taxes if hedge fund investments produce UBTI, particularly from leveraged activities. The TCJA’s silo rule mandates that tax-exempt investors conduct separate calculations of UBTI for each distinct trade or business activity, thereby prohibiting the offsetting of losses between them.
• State and Local Taxes: Hedge fund income is typically subject to state and local taxes. The $10,000 SALT deduction cap, effective through 2025, significantly impacts high-tax states. Numerous investors are utilizing Pass-Through Entity Tax (PTET) elections to mitigate the impact. Because PTET election rules can vary by state, consult with your tax advisor to understand eligibility and benefits based on your location.
• Alternative Minimum Tax (AMT) and Net Investment Income Tax (NIIT): While fewer taxpayers are affected by the AMT, high-income investors still face the NIIT of 3.8% on investment income that exceeds certain thresholds ($200k for single filers, $250k for joint filers) as outlined by the IRS.

Conclusion

Investing in hedge funds requires careful tax planning due to complex and evolving regulations. It’s important to understand fund structure, deduction eligibility, capital gains treatment, foreign reporting obligations, and taxes such as NIIT.

A qualified tax advisor can help you navigate hurdles and ensure your hedge fund strategy follows tax laws.

Connect with your advisor today to evaluate your portfolio and craft a plan tailored to your long-term financial goals.

LBMC tax tips are provided as an informational and educational service for clients and friends of the firm. The communication is high-level and should not be considered as legal or tax advice to take any specific action. Individuals should consult with their personal tax or legal advisors before making any tax or legal-related decisions. In addition, the information and data presented are based on sources believed to be reliable, but we do not guarantee their accuracy or completeness. The information is current as of the date indicated and is subject to change without notice.