Alternative investments such as private equity, cryptocurrencies, and collectibles now represent a significant part of the investment arena, in particular to high-income individuals. These alternative investments can offer distinct advantages in the shape of portfolio diversification and the potential for higher returns, but they can come with equally distinct tax complications that need to be carefully planned for.
In this 2025 guide, we’ll explore the more popular alternative investments, offer an understanding of their key tax implications, and examine how platforms like Harness can improve the tax efficiency of alternative investment strategies.
Table of Contents
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- What are alternative investments?
- What are the key tax strategies for alternative investments in 2025?
- What are the tax implications of the specific alternative investment types in 2025?
- What are tax-efficient alternative investment structures?
- Tax strategies for high-income filers
- How Harness can help
- FAQs
What are alternative investments?
Alternative investments encompass a broad range of assets beyond traditional stocks, bonds, and cash. Some of the more popular alternative investment types include:
Hedge funds: Privately managed investment funds that often employ sophisticated trading strategies.
Private equity: Investments in companies not listed on public stock exchanges, often involving buyouts or growth capital.
Real estate: Direct ownership of properties, ranging from residential to commercial, as an investment.
Venture capital: Funding provided to early-stage, high-growth potential startups.
Collectibles: Items with potential appreciation in value due to their rarity or cultural significance (art, antiques, etc).
Cryptocurrencies and digital assets: Decentralized digital or virtual currencies and other digital representations of value using cryptography.
Farmland: Investment in agricultural land for farming operations or appreciation.
What are the key tax strategies for alternative investments in 2025?
The alternative investment arena requires a clear understanding of several key concepts and strategies. Complicating matters is the potential sunset of the Tax Cuts and Jobs Act (TCJA) at the end of 2025, with investors in alternative assets needing to prepare for a broad range of tax changes that could come into play.
Capital gains vs. ordinary income
The distinction between capital gains and ordinary income is fundamental in alternative investments. Hedge fund profits, for example, may be short-term gains (or ordinary income), while private equity gains tend to be long-term (or capital gains). Most importantly, the two areas are taxed differently.
Ordinary income is taxed at the individual’s regular income tax rates, which in 2025 can range from 10% to a potential pre-TCJA rate of 39.6% for the highest earners should the TCJA expire. Capital gains, on the other hand, arise from the sale of capital assets held for investment.
The tax rate for capital gains depends on the holding period:
Short-term capital gains: Profits from assets held for one year or less are taxed as ordinary income.
Long-term capital gains: Profits from assets held for more than one year are taxed at preferential rates. For 2025, these rates are 0%, 15%, or 20%, depending on the taxpayer’s taxable income. As mentioned, it’s important to monitor potential changes if the TCJA provisions expire. In particular, the top long-term capital gains rate could revert closer to ordinary income rates for high-income earners.
Carried interest
For investors in private equity and hedge funds, carried interest—essentially, the managers’ share of profits—directly reduces the net returns an investor receives. With a larger carried interest percentage, a smaller share of the gains is distributed to investors.
While the tax treatment of carried interest primarily affects managers, future legislative changes may increase the tax burden on carried interest (by taxing it as ordinary income), which could result in adjustments to fund fee structures and impact the returns available to investors.
K-1 reporting
Many alternative investments, particularly those structured as partnerships or LLCs, report an investor’s share of income on Schedule K-1. A K-1 form details the various items that flow through to an investor, such as ordinary business income, rental real estate income, capital gains, interest income, dividends, and various deductions and credits.
The preparation of K-1s can be complex, especially for individuals with multiple investments. Delays in completing K-1 forms as a result of this complexity are a common part of the process and often require filing Form 4868 for a tax extension to avoid penalties. If a K-1 is late, investors may need to estimate figures or file Form 8082 should discrepancies arise.
Unrelated Business Taxable Income (UBTI)
Unrelated Business Taxable Income (UBTI) is income earned by a tax-exempt entity (like an IRA or pension plan) from a trade or business that’s not substantially related to the organization’s exempt purpose. Certain alternative investments held within these accounts, such as interests in limited partnerships that generate active business income, can trigger UBTI.
If the total positive UBTI across all applicable investments in a retirement account equals $1,000 or more, the tax-exempt entity is required to file Form 990-T and pay tax on the UBTI. This is an important consideration for high-income individuals using tax-advantaged retirement accounts for alternative investments.
State and Local Taxes (SALT)
Income from alternative investments is also subject to state and local taxes (SALT), with the tax treatment varying significantly by jurisdiction. High-income filers, especially those residing in states with higher income tax rates, need to consider the state tax implications of their alternative investments.
The TCJA imposed a limitation on the deduction of state and local taxes, currently capped at $10,000 per household. The potential sunset of the TCJA could alter these limitations, either increasing or eliminating them, which would directly impact the after-tax returns for investors in high-tax states. It’s important to monitor state conformity to federal tax changes, as some states may automatically adopt federal changes while others may decouple.
What are the tax implications of the specific alternative investment types in 2025?
Beyond the broader tax concepts that apply to alternative investments, there are specific tax implications that depend on the type of alternative asset being invested in.
Hedge funds
Hedge funds are often structured as limited partnerships, passing through gains and losses directly to their investors, who report these on their individual tax returns (Schedule K-1). The tax treatment of these gains can involve both short-term and long-term capital gains, as well as ordinary income, depending on the fund’s trading strategies and the holding periods of the underlying investments.
When it comes to tax efficiency, offshore hedge funds can offer tax advantages for non-U.S. resident investors. Strategies like tax-loss harvesting, where losing investments are sold to offset gains, and the careful timing of profit and loss realization are also important factors in optimizing after-tax returns. Close collaboration with tax advisors is highly recommended for hedge fund investments.
Private equity
Profits from private equity investments are typically taxed as capital gains, with investments held for over a year qualifying for long-term capital gains rates.
Qualified Small Business Stock (QSBS) under Section 1202 offers an additional potential benefit. BSBS excludes capital gains from federal taxes on investments in eligible small businesses held for at least five years, potentially excluding 100% of the gains up to certain limits ($10 million or 10 times the basis). That said, the QSBS exclusion is currently under scrutiny and could be reformed in 2025, so investors should monitor any potential changes.
Real estate
Real estate investments offer a unique set of tax advantages. Unlike more liquid asset classes, real property offers specific avenues for tax optimization, making it an attractive component of many high-income filers‘ portfolios.
Depreciation allows investors to deduct the cost of their properties over their useful lives (27.5 years for residential, 39 years for commercial), reducing taxable income. However, these deductions may be recaptured and taxed upon sale.
1031 exchanges allow investors to defer capital gains taxes when exchanging one investment property for another “like-kind” property, facilitating continuous reinvestment.
When it comes to real estate, it’s important to distinguish between passive income (minimal investor involvement, such as typical rental income) and active income (material involvement, such as property development) as they are treated differently by the IRS. The key difference is loss deductibility: passive losses are limited, while active losses have broader offset potential.
Additionally, bonus depreciation may apply to qualified improvement property (QIP), allowing for potential immediate expensing of certain interior non-residential improvements, offering a major upfront tax advantage.
Venture capital
Gains from venture capital investments are taxed as capital gains, with long-term holdings again qualifying for lower rates. The QSBS provision is particularly relevant for venture capital, allowing for the exclusion of capital gains from investments in qualifying small businesses.
The tax implications surrounding exit events like IPOs or acquisitions for venture capital investments can be significant, often triggering taxable events for investors. The form of consideration received—whether cash or stock in the acquiring company—plays a key role in determining the tax consequences, particularly regarding the timing of capital gains recognition.
It’s also worth noting that certain regions actively encourage investment in early-stage companies by offering various tax incentives. These incentives can include things such as income tax relief, capital gains tax exemptions upon disposal, or loss relief against income, all of which aim to reduce the inherent risks associated with ventures and stimulate innovation.
Crypto and digital assets
The current tax treatment of cryptocurrencies and digital assets remains a subject of ongoing debate and IRS guidance. Currently, the IRS generally treats crypto as property, meaning that selling or trading crypto typically triggers capital gains or losses. The inherent volatility of the crypto market can lead to frequent trading, potentially generating numerous taxable events throughout the year.
The dynamic nature of cryptocurrencies as an asset class has resulted in further tax considerations that investors must manage carefully:
Taxation of mining income: Income earned through cryptocurrency mining is treated as ordinary income for tax purposes. What’s more, individual miners may also be subject to self-employment taxes on this income, adding to their overall tax burden.
Reporting and compliance mandates: The Internal Revenue Service (IRS) requires comprehensive reporting of all cryptocurrency transactions, encompassing purchases, sales, and exchanges. Strict adherence to these reporting requirements is vital, with failure to comply resulting in major financial penalties.
Collectibles
Collectibles encompass a broad range of assets from fine art and antiques to stamps and comic books. When collectibles are sold at a profit, they qualify as capital gains. These gains are subject to a maximum federal income tax rate of 28%, which is higher than the general long-term capital gains rates that apply to most other types of capital assets held for over a year.
Tax considerations regarding collectibles include:
1031 Exchange for art: While less common and subject to specific, often stringent, criteria, a 1031 exchange (like-kind exchange) might be possible for certain exchanges of artwork. This would allow for the deferral of capital gains taxes when one qualifying artwork is exchanged for another.
Business ownership and deductible costs: If artwork or other collectibles are held through a legitimate business structure (and not purely for personal enjoyment), certain ordinary and necessary business expenses related to their ownership, such as secure storage costs and insurance premiums, might be deductible. The key here is that the holding and maintenance of the collectible must be directly related to the business activity.
Charitable donations: Donating artwork or other collectibles to qualified charities can offer income tax deductions. The amount of the deduction usually depends on factors such as the type of charity, the fair market value of the donated item, and the donor’s holding period. For high-value donations (typically over $5,000), a qualified appraisal is usually required.
Farmland
Income generated from the daily operations of a farm, such as the sale of harvested crops or raised livestock, is typically treated as ordinary income for tax purposes. However, when the farmland itself is sold, any resulting profit can often qualify for the more favorable long-term capital gains tax rates.
To further support agricultural businesses, tax law allows farmers to claim depreciation on essential farm equipment. Additionally, the Section 179 deduction offers the potential for immediate expensing of certain qualifying property, with a 2025 limit of $1,250,000, providing a major upfront tax benefit.
Engaging in conservation by donating conservation easements can also deliver valuable income tax deductions. Beyond this, income gained from farming activities may be eligible for the Qualified Business Income (QBI) deduction, a provision set to expire at the end of 2025 unless legislative action extends it.
For long-term estate planning, Section 2032A offers special valuation rules for farmland, which can ease the burden of estate taxes. Finally, the level of the farmer’s involvement in agricultural activities dictates whether income or losses are classified as passive or active and impacts how they are treated for tax purposes.
What are tax-efficient alternative investment structures?
The legal structure used to hold alternative investments can have a profound impact on their tax treatment. The two most common structures used are Limited Partnerships (LPs) and Limited Liability Companies (LLCs).
Limited Partnerships (LPs)
Private equity and hedge funds often use the LP structure. LPs have general partners (GPs) who manage the partnership and who have unlimited liability—as well as limited partners (LPs) who are typically passive investors with limited liability.
LPs are pass-through entities, meaning the partnership itself does not pay income tax. Instead, profits and losses are allocated to the partners and reported on their individual tax returns via Schedule K-1. There is an additional partnership agreement dictating how profits and losses are allocated among the partners.
Limited Liability Companies (LLCs)
Real estate special-purpose vehicles (SPVs) often use the LLC structure due to its limited liability protection. LLCs offer flexible management (member or manager-managed) and default to pass-through taxation.
While single-member LLCs can be sole proprietorships for tax purposes, multi-member LLCs in alternative investments are frequently taxed as partnerships, issuing Schedule K-1s. Similar to an LP’s partnership agreement, an LLC’s operating agreement dictates how profits and losses are allocated among members, directly impacting individual tax liabilities.
Tax strategies for high-income filers
There are a number of strategies high-income filers can pursue to improve the efficiency of alternative investments.
Tax-efficient structuring
Beyond LPs and LLCs, alternative investments can be held in other tax-advantaged ways, such as certain trust structures or retirement accounts (where permissible). The specific structure chosen should align with the investor’s overall tax and estate planning goals.
Timing of investments and dispositions
The timing of buying and selling assets can significantly impact tax liabilities. Strategically timing the sale of assets held for just under a year versus slightly longer can determine whether the gains are taxed at higher short-term or lower long-term capital gains rates. Tax-loss harvesting, the practice of selling losing investments to offset capital gains, can also be a valuable strategy.
Using available deductions and credits
It’s important to make sure that all applicable deductions and credits are used. Investors should be aware, however, that certain deductions, like the SALT deduction, may be subject to limitations that could change with the TCJA sunset.
The importance of accurate record-keeping
Investors should maintain precise and comprehensive records of all alternative investment transactions, including purchase dates, cost basis, sale proceeds, and any associated expenses. This is crucial for efficient tax reporting and minimizing the risks of non-compliance and penalties.
How Harness can help
Given the complexity of alternative investment taxation—and the imminent potential expiry of the TCJA—it’s highly advisable for high-income filers to work with experienced tax advisors who specialize in the alternative investment field.
A tax advisor from Harness can provide tailored guidance and advice, helping you understand the specific tax implications of your investments, maintain accurate reporting, and design strategies to keep your alternative investments tax-efficient.
FAQs
Common questions regarding alternative investments include:
When selling an alternative investment, what are gross proceeds, and how does backup withholding potentially apply?
Gross proceeds represent the total money received from the sale before any deductions. Backup withholding might occur if you haven’t provided a correct Taxpayer Identification Number (TIN) or have a history of underreporting interest or dividends. A tax professional can help ensure proper documentation to avoid this.
When dealing with complex alternative investments, why is it crucial to consult a tax professional?
A tax professional specializing in alternative investments possesses the expertise to manage intricate structures, reporting requirements like Schedule K-1, and the subtleties of the tax code, ensuring compliance and identifying potential tax optimization strategies beyond what a general tax preparer or mutual fund advisor might offer.
Are all capital gains from alternative investments taxed at the same rate?
No, not all capital gains are taxed at the same rate. Short-term capital gains are taxed at your ordinary income tax rate, while long-term capital gains have preferential rates. Collectibles also have a maximum rate that differs from the general long-term rate. The holding period and the type of asset dictate the applicable payment of tax.
What are the tax implications if I decide to transfer my ownership in an alternative investment to another party?
The transfer of your ownership can trigger taxable events, similar to a sale. The tax consequences depend on the type of investment, your basis, and the value at the time of transfer. The payment of any resulting tax is your responsibility as the owner.
If I receive miscellaneous income from an alternative investment reported on a specific tax form, how do I determine its correct tax treatment?
The specific tax form (often a K-1, not a 1099-MISC for typical miscellaneous income) will provide details. However, a tax professional can best interpret this information, considering your ownership stake and financial interest in the investment, to ensure accurate reporting under the relevant sections of the tax code.
Disclaimer:
Tax-related products and services provided through Harness Tax LLC. Harness Tax LLC is affiliated with Harness Wealth Advisers LLC, collectively referred to as “Harness Wealth”. Harness Wealth Advisers LLC is a paid promoter, internet registered investment adviser. Registration does not imply a certain level of skill or training. This article should not be considered tax or legal advice and is provided for informational purposes only. Please consult a tax and/or legal professional for advice specific to your individual circumstances. This article is a product of Harness Tax LLC.
Content was prepared by a third-party provider and not the adviser. Content should not be regarded as a complete analysis of the subjects discussed. Although we believe the content is reliable, it is not guaranteed as to accuracy and does not purport to be complete nor is it intended to be the primary basis for financial or tax decisions.
