Investment managers, hedge fund managers, and financial services professionals face a specialized tax environment built around three pivotal provisions: the carried interest rules that determine when fund profits are capital gain vs. ordinary income, the §1256 60/40 blended rate that applies to futures and certain options, and the trader vs. investor distinction that controls whether mark-to-market accounting is available. Getting these right is the difference between a 20% and a 37% effective rate on the same economic income.
Carried interest: A fund manager's profits interest (the "carry") is taxed as capital gain if the underlying assets are held for more than 3 years, per the OBBBA three-year holding period requirement under IRC §1061. Assets held 3 years or less produce short-term capital gain or ordinary income on the carry regardless of how long the fund manager held the profits interest itself.
§1256 contracts: Regulated futures contracts, foreign currency contracts, dealer equity options, and certain other contracts are marked to market at year-end and taxed at a blended rate: 60% long-term capital gain / 40% short-term capital gain, regardless of actual holding period. The effective top rate is approximately 26.8% (60% x 20% + 40% x 37%) for high-income taxpayers.
Trader vs. investor: A trader in securities who is in the trade or business of trading may elect mark-to-market accounting under §475(f), converting all gains and losses to ordinary income/loss. This eliminates the capital loss limitation, allows full deduction of trading losses against ordinary income, and avoids wash sale rules - but also converts all gains to ordinary income.
A carried interest is a profits interest in an investment fund - the manager receives a percentage of fund profits (typically 20%) as compensation for managing the fund, without contributing corresponding capital. Before the TCJA, carried interest gains were taxed at long-term capital gain rates if the underlying fund assets were held more than one year. TCJA added IRC §1061, requiring a three-year holding period in the fund's underlying assets for the manager's carried interest gains to qualify as long-term capital gain. Assets held one to three years produce "applicable partnership interests" gain taxed as short-term capital gain at ordinary income rates.
Section 1256 contracts - regulated futures contracts, foreign currency contracts traded on exchanges, non-equity options, and dealer equity options - are marked to market at year-end. Open positions are treated as if sold at fair market value on December 31. The gain or loss is characterized as 60% long-term capital gain/loss and 40% short-term capital gain/loss regardless of how long the position was held. This blended rate is more favorable than pure short-term treatment for active traders who turn over positions frequently. The §1256 mark-to-market rules are mandatory - they cannot be opted out of for covered contracts.
Net §1256 losses can be carried back three years (applied only against §1256 gains in those years) in addition to the standard capital loss carryforward. This carryback feature is unique to §1256 losses and provides valuable tax recovery for traders with significant futures losses.
The distinction between a trader and an investor in securities is one of the most litigated individual tax issues. A trader: trades for their own account with frequency, regularity, and continuity; seeks to profit from short-term price swings rather than long-term appreciation or dividends; and spends substantial time in trading activity. An investor: holds securities for capital appreciation and dividends; does not trade with sufficient frequency to constitute a trade or business.
Traders may deduct trading expenses on Schedule C as business expenses (not subject to the 2% AGI floor that limited miscellaneous itemized deductions pre-TCJA). Investors deduct investment expenses only to the extent allowed - currently most investment expenses are nondeductible under TCJA. The §475(f) mark-to-market election is available only to traders and is made by the April 15 deadline (or extension deadline) of the year before it takes effect.