Hedge funds are a popular form of investment that have both benefits and possible complications for the investor. Here’s a look at what a hedge fund is, some of its advantages and a few tax implications you should be aware of.

What is a Hedge Fund?

A hedge fund is an investment pool, generally limited to high-net-worth individuals and institutions. There is no legal definition of a hedge fund, but most share the following traits:

  • they invest in a wide range of securities and assets (stocks, currencies, derivatives, private equity)
  • compensation of the manager is based on a percentage of assets and capital appreciation
  • leverage is often used (borrowing money to add to an investment position in order to increase returns)
  • hedge funds are taxed as pass-through entities and issue a K-1 to each investor.
    Some strategies that attempt to exploit small pricing discrepancies in the marketplace require large amounts of leverage in order to generate an attractive return for investors.

Benefits of Hedge Funds

The deductibility of expenses depends on the type of fund — trader or investor. A trader is someone who aims for rapid portfolio turnover, whereas an investor is someone who tends to hold securities for a longer duration. The trader fund investor can deduct all ordinary and necessary expenses paid or incurred. An investor in an investor fund can deduct these expenses as well, but they will be classified as miscellaneous itemized deductions and subject to the 2 percent of adjusted gross income (AGI) limitation.

Hedge funds often have investment interest expense, since they make use of leveraging. To the extent the interest expense exceeds investment income, the excess is carried forward indefinitely. Investment income is income from investment property that produces portfolio income — interest, dividends, annuities, royalties. Long-term capital gains and qualified dividends are not included in investment income unless the taxpayer makes an election to tax these items at ordinary rates.

Hedge funds that qualify as trader funds are generally not subject to passive activity loss limitations, which means investors can use their share of hedge fund ordinary losses to offset unrelated active ordinary income, such as salary, and capital losses from the fund may offset unrelated capital gains.

Complications of Hedge Funds

Hedge funds are often a mix of trader and investor activities and include both nonpassive and passive income. This adds complexity for tax return preparers, having to break out income and expenses to different pools. This can be very time consuming and might require additional tax preparation fees.

Additionally, the hedge funds may not issue their Form K-1 to the investor by April 15, requiring an extension of the investor’s tax return.

Investing in hedge funds might also mean additional filings and forms related to foreign holdings and activities. There are hefty penalties for not filing these forms, so an oversight could be a very pricey mistake.

A hedge fund can be a great investment but can also present complications when tax time rolls around. Just be sure you’re aware of the implications and that you consult with your tax advisor regarding your personal situation.

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.