Tax Considerations for Hedge Funds as 2022 Nears Its End
By Andrew Walker, CPA, Tax Supervisor, Alternative Investment Group
As we edge closer to year-end, now is a good time to make sure there are no surprises regarding your 2022 taxable income. Below are some of the more common tax adjustments made by investment funds at year-end to neutralize potentially negative results.
Internal Revenue Code (IRC) Section 1091 defines the wash sale rules, under which a loss on a security is deferred due to the purchase of a substantially identical security within a 61-day period. This period includes the 30 days before and 30 days after the security is sold for a loss. The reasoning behind this code section is to disallow taxpayers from selling a depreciated security for tax purposes while remaining in a relatively unchanged economic position. Losses disallowed under the wash sale rules are added to the tax basis of the new securities acquired, resulting in a reduction of future gains or an increase in future losses.
It is advisable to review your realized losses for the 2022 tax year now and to make sure you have not purchased substantially identical securities within a 61-day period, which could create a wash sale. Luckily, there is still time to liquidate any wash-sale securities before year-end; be certain not to repurchase a substantially similar security for at least 30 days.
January 2023 transactions need to be taken into consideration when computing wash sales. Keep this in mind before executing the repurchase of a security sold for a loss in the final months of 2022.
As 2022 year-end approaches, you may be considering your tax situation with regard to the sale of a stock with a substantial amount of unrealized gain. A common strategy would be to short the stock and lock in the gain without realizing the taxable income. Before you do that, consider the Constructive Sale rules under IRC Section 1259. Constructive sales, also known as a ”short against the box,” are triggered when a long position with an unrealized gain is shorted against (these rules do not apply to loss positions). This creates a realized gain on your long position as if you sold the security when you entered the short position.
A straddle is a hedge utilizing options to offset positions when the investor is unsure of which direction a stock price will take and wants to limit potential tax exposure. To limit the extent of the potential tax advantage this strategy may create, Section 1092 limits the deduction of losses to the extent of the gain. Therefore, if a stock moves strongly in the direction of your put option, but you have a larger stake in your call option, you may only recognize the loss on your call option to the extent of the put option gain. Any excess loss is carried over to the following year.
Section 1256 Contracts
A Section 1256 contract is traded on a qualified board or exchange and is any regulated futures contract, foreign exchange contract (FEC), non-equity option, dealer equity option, or dealer securities future contract. A Section 1256 contract is effectively marked to market, and any gain or loss recognized, at the end of a given tax year. These are typically recognized at the tax rate of 40% short-term gain/loss and 60% long-term gain/loss. Many foreign currency contracts are marked to market at year-end but treated as an ordinary gain/loss unless a Section 988(a)(1)(b) election is in place. The list of such contracts meeting the mark to market requirement is constantly changing.
Corporate dividends declared but not paid in the current year are considered accrued dividends as of December 31, 2022 and will be excluded from your 2022 taxable income. This can limit deductions on certain dividends that corporate investors may otherwise claim on their own tax returns. Be mindful as you prepare your 2022 tax return that accrued dividends excluded in a prior year will likely be included this year (the year the dividend was paid).
Short Dividend Expense
When holding a short position that pays dividends, it is important to consider the effects of dividend expense. As you finalize your 2022 tax planning, be mindful of the period you have held your short position when a dividend is issued by a corporate stock in your portfolio. If you have held the position for more than 45 days, the dividend expense will be considered interest expense. If the position is held for 45 days or less, the dividend expense is reclassified to the basis of the short position and will reduce the potential capital gain or increase the potential capital loss.
Count on Marcum
Consult your Marcum tax professional to discuss planning opportunities around these or other scenarios.