The Consequences of Investing in Hedge Funds and Limited Partnerships

Hedge funds and master limited partnerships (MLPs) have their fans and can make sense for some investors.  However, they are incredibly complex and opaque, and not suitable for most people.

Hedge funds can be opaque, as they are not held to the same standard of disclosure as other investments, say, mutual funds.

MLPs are also tricky, although they are not considered in the same light as investments registered with the SEC.

Since they are partnerships, you buy into a partnership.  The industries an MLP can engage in are restricted by the IRS to natural resources and real estate and must derive 90% of their income from these 2.

Both are considered illiquid and suitable only for the most sophisticated of investor, and even then only for those with significant holdings they won’t need for decades; put another way, these are very, very long term holdings.

Additionally, they make income tax-filing time very, very complicated.

The form that income activity is reported to the IRS is called a Schedule K-1.

It may sound innocuous; it is anything but.

Because all income-related aspects of the partnership are included on the K-1, the ramifications are that there are many schedules and forms in your income tax filing that are affected.

From a Schedule K-1 filing, the various forms that are affected are:

1040: Everyone knows this one, but just in case, this is your main income tax filing form.

Form 4797: Sales of Business Property

 Schedule E: Supplemental Income and Loss

Form 1116: Foreign Tax Credit

Schedule B: Interest and Ordinary Dividends

Form 6251: AMT

Schedule D: Capital Gains and Losses

Form 4952: Investment Interest Expense Deduction

That’s 8 various forms that are affected by owning an investment that is structured to file a K-1, and on most of these forms there are 2 areas to report various aspects of the K-1 on.

This can add dozens of hours to your income tax preparation, and it goes without saying that this will elevate, if that’s the right term, your income tax needs from a Tax Preparer to a Tax Advisor.

So, when considering investing in a Hedge Fund or an MLP, factor in the significant cost these investments will bring at tax preparation time.