Interval Fund Essentials: Taxes

Interval funds, along with most other funds registered under the Investment Company Act of 1940 (the ’40 Act), are structured as Regulated Investment Companies (RICs). This configuration allows funds to be seen as “pass-through” entities in the eyes of the IRS, significantly reducing the complication and magnitude of their taxes.

Therefore, on top of their other advantages, interval funds can present investors with a tax-efficient opportunity to access a diverse range of alternative or illiquid assets without the complications of investing in them directly.

AVOIDING THE “DOUBLE DIP”

One of the most famous complaints with the American tax code centers on double taxation. When corporations make money, they’ll often distribute it back to their shareholders as dividends -- either cash or additional stock. However, corporations must first pay federal, state, and even municipal taxes on their earnings before distributing said dividends. This, naturally, makes the dividend payments smaller than they would have been pre-tax.

The headache arises from the fact that the dividends are taxed again as either capital gains or income once they reach shareholders.

The RIC structure avoids this. Registered funds like interval funds and ETFs, alongside private funds like hedge funds and private debt funds, avoid the initial taxes on their income through a requirement that they pass a high proportion of their profits directly on to shareholders. This is done through a “distribution,” and it ensures that the money is only taxed once – when it has reached the investor.

IRS Regulation M allows RICs like interval funds to access this preferential tax configuration so long as they distribute at least 90% of their profits back to shareholders every year. The profits a fund reports can be from payments by fixed-income securities like bonds, from dividends paid by the companies whose stock the fund owns, or from the sale of assets that have accumulated value throughout the year. All of that income is rolled into a shareholder's distribution, but the way it's taxed depends on its source. That taxation breakdown, as well as the form used to report it, are described below.

DISTRIBUTION TAXES

Interval funds receive passive dividend and interest payments from their holdings, and they regularly pass that money on to shareholders as distributions. In most cases, dividends come from a fund's stock holdings and interest comes from debt holdings like bonds. These two components of a shareholder distribution are taxed differently.

Interest from fixed-income securities is taxed at a person's regular income tax rate, which is covered in the next section.

Dividends are taxed based on whether they fall into either of two categories:

1. Qualified dividends

2. Ordinary (non-qualified) dividends

Qualified dividends are taxed as capital gains rather than income, which means they can fall into either the long- or short-term tax rates. This rate depends on how long the fund has held the stocks producing the dividends, not how long you've held shares in the fund. In order to be "qualified," dividends must meet the following two criteria:

• They must be issued by a U.S. company or a foreign company that trades on a major U.S. exchange.
• The stocks generating the dividend must be held for more than 60 days during a 121-day time frame. The start of this holding period is 60 days before the ex-dividend date, which is the first day of trading without any subsequent dividend.

In contrast, ordinary dividends are taxed at the rate of your current income bracket -- regardless of how long the fund has held the stock producing the dividend.

Interest and dividends are both generated passively, without the sale of securities. Thus, interest and ordinary dividends are both considered income and are taxed at the same rate as a person's regular earnings. However, when either a shareholder or the fund sells securities for a profit, that profit is considered a "capital gain" and is taxed according to how long the security was held. Those details are covered below.

Image by Kelly Sikkema

CAPITAL GAINS TAXES

Capital gains taxes come into play in three circumstances:

1. When a fund shareholder sells their shares

2. When a fund sells some of the securities it holds

3. When a fund receives and distributes qualified dividends, as defined earlier

In the first two cases, the capital gains tax depends on whether the share or security was held for a year or more. If a fund share is held for less than a year before it's sold, the proceeds are classified as “short-term gains” and are taxed at a higher level than for those held for a year or more. The same rule applies to the securities held by funds: if a fund buys a stock, holds it for less than a year, and then sells it and distributes the profits, the shareholders who collect those payments will see them taxed as short-term gains.

For qualified dividends, if the stock producing the dividend has been held for less than a year, the dividend is taxed as a short-term gain. Otherwise, it's taxed as a "long-term gain."

Although the difference between eleven months and twelve months may seem arbitrary, the differences between short-term capital gains taxes and long-term capital gains taxes are anything but. In order to incentivize stable, long-term capital investing and discourage speculative, casino-style day trading, an arbitrary distinction is set between the two types of sale-based income. Short-term gains are taxed at the same rate as income, while long-term gains are taxed at a significantly lower level.

According to the IRS, here’s how a single person’s annual income corresponds to the short- and long-term gains taxes they’ll pay:

· $0 to $9,875: 10% (short-term) & 0% (long-term)

· $9,876 to $40,125: 12% (short-term) & 0% (long-term)

· $40,000 to $40,125: 12% (short-term) & 15% (long-term)

· $40,126 to $85,525: 22% (short-term) & 15% (long-term)

· $85,526 to $163,300: 24% (short-term) & 15% (long-term)

· $163,301 to $207,350: 32% (short-term) & 15% (long-term)

· $207,351 to $441,450: 35% (short-term) & 15% (long-term)

· $441,451 to $518,400: 35% (short-term) & 20% (long-term)

· Over $518,400: 37% (short-term) & 20% (long-term)

Save for the subset of taxpayers making between $40,000 and $40,125 a year, every tax bracket has a higher rate for short-term gains than for long-term gains.

NOTE: In April 2021, President Biden proposed raising the long-term capital gains tax for Americans making more than $1 million a year from its current 20% to 39.6%. This would affect both the taxes paid on securities held for longer than a year and those paid on qualified dividends.

REALIZED VS. UNREALIZED GAINS

Investors who individually hold securities like stocks or bonds are taxed on the distributions and interest payments those securities generate, but they aren’t taxed on their ownership until they sell them. This is the difference between realized and unrealized gains. If a person buys a stock and holds it until it doubles in value, she isn’t taxed on that value increase until she sells the stock and realizes a profit.

This distinction is important to fund investors as well, and it's often misunderstood. Even if you hold onto your interval fund shares indefinitely, you'll still be subject to taxation on the fund's annual distributions. However, if the value of an interval fund's shares increases while you hold them, you won't be taxed on that increase until you sell the shares and realize a profit.

Because of the unique liquidity structure of interval funds, investors often adopt a long-term holding strategy for their shares. Even when the fund offers to buy back shares, many will choose to keep their money invested in the fund. But, because of the regulatory requirements that allow RICs to exist as “pass-through” conduits for capital, interval funds must distribute at least 90% of each year’s investment income back to shareholders as taxable distributions.

Although distributions are always technically given in cash, shareholders can elect to set up distribution reinvestment plans, or DRIPs, to automatically invest their distribution payments back into the fund. The details and availability of DRIPs vary fund-by-fund, and they should be enumerated in the fund’s prospectus.

Image by Damir Spanic

FORM 1099-DIV

Before January 31 of each year, regulated investment companies like interval funds will provide shareholders with documentation of their distribution payments and capital gains from that year on Form 1099-DIV. Compared to the K-1 filing used by partnership structures like hedge funds and private equity funds, 1099-DIV is quite streamlined.

1099-DIV, which is sent to both the taxpayer and the IRS, enumerates the quantity and type of income the fund has generated for shareholders that year. This includes:

· Distribution payments (broken down into interest income, ordinary dividends, qualified dividends, and capital gains from the fund's sale of securities)

· Shareholder capital gains from the sale of the fund's shares

If the sum of a person's income from interest and ordinary dividends is greater than $1,500, they must declare it in Schedule B of Form 1040 with that year’s taxes. All of a person's capital gains and qualified dividend income must be reported on Schedule D.

Because the accounting for each investment’s valuation and sale is done by the fund’s accountant, shareholders are spared the effort of grappling with the transactional paper trails of the holdings their shares represent. Though the distinctions between ordinary dividends, qualified dividends, interest, and capital gains may be confusing, the simplified, pass-through taxation structure of RICs like interval funds make them an expedient option for retail and institutional investors alike.

Next: Interval Funds vs. ETFs