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Hedge Fund Taxation

Hedge Funds

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Please note that this section on Hedge Fund Taxation was written specifically for the United States. While certain underlying principles will apply to investing in general, please check your local nation’s tax regulations if you live outside of the US.

Once invested, your return divides into the two typical divisions of capital gains and income. Your distributions change depending on your hedge fund’s policies and strategy. These divisions matter, tax treatments change based on the income type. Hedge fund taxation is not paid by a hedge fund, but is passed on to the investors within the fund. Investors pay tax bills based on the categorization of hedge fund returns.

Hedge Fund Taxation: Income Gains, Income Taxes

Income based earnings are taxed at your normal income tax bracket. Income tax is typically applied to earnings from dividends, interest payments, and rental payments. Dividends are an exception, as they are taxed lower than income. If your hedge fund earns returns which qualify as income, the fund will generate a higher tax bill for investors. Income distributions earned by a fund are usually kept to purchase future investments, but they may also be paid out. If income taxes are incurred by the hedge fund you will receive documentation alerting you to the amount of money earned, and allowing you to potentially calculate your future tax obligations. These notifications are usually delivered towards the end of the fiscal year or shortly into the beginning of the next fiscal year.

Hedge Fund Taxation: Capital Gains, Reduced Taxes

Capital gains operate differently than income both in returns and taxation. Capital gains are earned by the increase of value in assets, which are not actively delivering income while they are held. Capital gains are unrealized until the assets creating them are sold. On sale, they may be reinvested in other assets within a fund, or distributed to investors. Taxes are not paid on capital gains until sold, and they are taxed at a lower rate than income. Capital gains are also reduced by capital losses, up to an annual limit. Losses in excess of these values can be carried over into the next year, up to the same annual limit.

Note that capital gains taxation rates differ based on the length of time the assets were held. Short term capital gains consist of a one year holding period or less. These gains are taxed as regular income. Long term capital gains are applied to assets held longer than one year. A fund generating short term income taxes (which would become capital gains if held longer) are generating a completely avoidable tax bill for their investors.

Hedge Fund Taxation: Watch Your Tax Categorization

The variety of taxes potentially incurred modifies your gains from the fund. Investors who own funds with fairly solid returns can suffer deep earnings reductions due to earnings being classified as income tax. Pay attention to the effect of hedge fund returns before and after taxes, especially if your investment is triggering taxes with very little profit.

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