Hedge funds are somewhat akin to mutual funds on steroids, as their limited investment restrictions allow them to pursue high-risk, high-reward scenarios. Typically, you can only invest in a hedge fund if you are an "accredited investor," meaning you have lots of investment experience, lots of money, or both. However, when it comes time to paying taxes, as an investor you won't find much difference between a hedge fund and a mutual fund.
If your hedge fund is set up as a partnership, as many of them are, you'll get all of your tax information at year-end on a Schedule K-1. Otherwise, you may receive a Form 1099. Schedule K-1 lists all the distributions that a hedge fund made during the year, from dividends to interest payments to capital gains distributions.
Regardless of the type of payment listed on your Schedule K-1, you'll be taxed on it as if you were the owner of the investment itself rather than as a hedge fund investor. You'll have to transfer any information you receive from Schedule K-1 to your Form 1040 or Form 1040A to pay the correct taxes -- unless your hedge fund investment is in a tax-advantaged account, such as an IRA, taxes on which typically are deferred until you take money out.
The rate you pay on any capital gains you receive from a hedge fund depends on your income, your tax filing status, and the length of time the fund held the investment. For tax year 2012, long-term gains, which are reported on line 9a of Schedule K-1, are taxed between 0 percent and 15 percent. For 2013, the maximum rate climbs to 20 percent and a Medicare surcharge kicks in if your modified adjusted gross income as a joint filer exceeds $250,000. Short-term capital gains, those held for one year or less, are taxed as regular income. For 2012, this means your short-term gains would be taxed between 10 percent and 35 percent, with the top rate rising to 39.6 percent in 2013.
Dividends & Interest
Regular dividends and interest paid out by a hedge fund are taxable to you at your ordinary income tax rate, the same as short-term capital gains. Qualified dividends, which would be listed on line 6b of your Schedule K-1, benefit from the long-term capital gains rate. Depending on your tax bracket, you could pay up to 23.8 percent on your qualified dividends.
Sometimes, a hedge fund may make more exotic payouts than the traditional income and capital gains. For example, some hedge funds may pay out "unrelated business taxable income," which becomes taxable to you even if paid into an IRA. Schedule K-1 also lists many lesser-used entries that could have varying tax effects, such as gains and losses on collectibles, an unrecaptured section 1250 gain, and a section 179 deduction. While you'll pay tax on any distributions as an individual investor, you may have to consult with a tax expert to understand the financial intricacies of certain hedge fund payouts.
After receiving a Bachelor of Arts in English from UCLA, John Csiszar earned a Certified Financial Planner designation and served 18 years as an investment adviser. Csiszar has served as a technical writer for various financial firms and has extensive experience writing for online publications.