2017 Essential Tax and Wealth Planning Guide
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Tax implications of fund investing
Types of investment funds
and income tax characteristics
The character of income and loss allocable to investors directly impacts after-tax
returns on investments and can vary significantly between types of funds.
2017 Essential Tax and Wealth Planning Guide | Tax implications of fund investing
47
Introduction
What is an investment fund?
Types of investment
funds and income tax
characteristics
• Marketable securities
Hedge funds
• Private equity/venture capital
.
Publicly traded partnerships
Real estate funds
.
Fund of funds
Investment fund attributes
• Trader versus investor
entities
Passive versus
non-passive income
Separately stated activity
(including PTPs)
Qualified small business
stock (QSBS)
Unrelated business
taxable income
• State tax reporting
Conclusion
.
Resources
Marketable security funds
Marketable security funds (MSF) are
investment funds that typically trade in
stocks, bonds, and other marketable
securities on the behalf of their partners.
The purpose of these investments is to
provide portfolio diversification by pooling
capital from investors and investing in a
broad base of investments. Many MSFS
have an investment strategy targeted to a
specific asset class such as small cap, large
cap, international, or emerging markets,
while other funds may look to invest more
holistically across multiple strategies.
Leverage is typically not utilized by MSFs.
Investments in MSFS are relatively liquid
allowing investors to contribute cash or
make withdrawals on a frequent basis
such as monthly. Depending on whether
a partner's investment in the MSF is in
an appreciated or depreciated state, as
compared to the partner's tax basis in the
MSF, many MSFS will allocate additional
gains or losses to partners at the time they
redeem some or all of their interest in a MSF
in an effort to eliminate or limit this disparity.
Character of income
considerations-MSF
The investment strategy of a MSF directly
impacts the character of the income and
loss generated by the fund. The character
of income and loss allocable to investors
directly impacts after-tax returns on
investments and can vary significantly
between types of funds. As a result, having a
good expectation of this impact is important
when making investments. MSFs typically
invest in marketable securities and generate
dividends, interest, tax-exempt interest,
capital gains, foreign taxes, and expenses.
Preferential income tax rates are available
for qualified dividends and long-term capital
gains. If a MSF is considered in the trade
or business of trading securities (discussed
further on page 57), the expenses can
be tax effective and offset an investor's
ordinary income from other sources.
Additional information is available in the
Individual Income Tax Planning section of
the 2017 Essential Tax and Wealth Planning
Guide regarding income tax rates, types of
income, and planning considerations.
Hedge funds
Hedge funds (HF) are investment funds that
can use one or more alternative investment
strategies, including hedging against market
downturns, investing in asset classes such
as currencies or distressed securities, and
utilizing return-enhancing tools such as
leverage, derivatives, and arbitrage.³ Many,
but not all, HF strategies tend to hedge
against downturns in the markets being
traded. HFs are flexible in their investment
options (can use short selling, leverage,
derivatives such as puts, calls, options,
futures, etc.).4 There is typically broad
discretion over investment objectives,
asset classes, and investment vehicles.
Use of leverage
HFs typically utilize leverage to execute
their investment strategy. Many HFs will buy
securities on margin to increase the amount
of exposure to a strategy. For example, if a
HF received capital contributions from its
investors of $10,000,000, by using leverage,
it may be able to borrow $5,000,000
(buying on margin) so that it is able to invest
$15,000,000. To the extent the HF can
borrow assets to purchase more securities,
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3 Per http://www.hedgefundassoc.org/about_hedge funds
4 Per http://www.hedgefundassoc.org/about_hedge_fundsView entire presentation