Although few hedge funds are designed as income investments, they sometimes send checks to their investors. The checks may be distributions of income, or they may be returns of capital. The difference may appear academic on the surface, but it affects your portfolio —especially when it comes time to pay your taxes. Which distribution is which, and why do the funds start sending you checks like grandma on your birthday? Read on to find out!
Income: Income is money generated from interest, dividends, rental payments, and similar sources. Hedge funds usually reinvest income into their funds, but sometimes they pay it out to their investors. You may receive a check to help you meet your tax obligations, or your fund may send it to manage the size of its investable assets.
Returns of capital: Capital gains are profits made when an investment goes up in price. These gains are paper gains when the fund still holds the asset that goes up in price, and realized gains when the fund sells the asset, locking in the profit in the process. Realized gains are taxable, but paper gains are not. In most cases, hedge funds want to reinvest their capital gains into new investments. However, your hedge fund may send you a check for your capital gains, reducing the amount of principal in the fund.You may think that income and capital gains are the same thing, but they arent. The government taxes them at different rates, and people handle them differently for accounting purposes. In most cases, capital gains are taxed at lower rates than income, which is enough of a reason to keep them separated. See the section “Your Tax Responsibilities” for more information.
Managers of top – performing funds have been known to kick investors out.
The policy may screw up your portfolio, and all the paper gains will suddenly fall into the realized category.
