Alternative Investments Explained: What Are They, And How Are They Taxed?

Alternative investments offer investors access to startups, real estate, and other non-traditional opportunities beyond stocks and bonds. However, unlike stocks and bonds, alternative investments, or “alts” as they’re commonly known, have unique tax treatments and complex reporting requirements that investors should carefully consider before investing.

In this article, we’ll explore all the details of alternative investments, the reasons behind their growth as an investment choice, and how their tax treatment differs from traditional assets. We’ll also go into some potential strategies to optimize tax efficiency.

Table of Contents

1. What Are Alternative Investments?
2. What Are the Different Types of Alternative Investments?
3. How Are Alternative Investments Taxed?
4. What Are the Tax Strategies for Alternative Investments?
5. How Do I Invest in Alternative Investments?
6. Frequently Asked Questions (FAQs)

What Are Alternative Investments?

Alternative investments cover a wide range of asset types, offering exposure to everything from private companies to real estate, fine arts, and even collectible cars. Many investors turn to alts for portfolio diversification and the potential for high-growth opportunities. However, alternative investments may be less liquid, can require longer holding periods, and can come with distinct tax considerations, such as Schedule K-1 reporting and specialized deductions.

What Are the Different Types of Alternative Investments?

Below are some of the most common types of alternative investments, along with their associated risks and eligibility requirements.

Private Equity

Private equity (PE) involves investing in privately-held companies that are not publicly traded on stock exchanges like Nasdaq or the NYSE. PE investments typically require long holding periods and high capital commitments, but they offer the potential for attractive returns. Private equity investments are generally not made available by traditional brokerages, and dedicated alternative investment platforms and marketplaces such as iCapital can help accredited investors find private equity investment opportunities.

• Risks: Lack of liquidity, long lock-up periods (5-10+ years), dependence on fund manager performance, concentration risk, and difficulty in accurately valuing investments.
• Eligibility: Typically requires accredited investor or qualified purchaser status due to regulatory requirements.

Venture Capital

Similar to private equity, venture capital (VC) and startup secondaries are also investments made in privately-held companies, but the landscape differs slightly, focusing on smaller, early-stage companies rather than larger or more mature privately-held enterprises. For VC and startup investments, platforms such as AngelList and Hiive offer solutions to individual investors.

• Risks: High failure rates among startups, long holding periods, limited transparency, difficulty in liquidating investments, and unpredictable returns.
• Eligibility: Usually requires accredited investor status. Some secondary market platforms allow non-accredited investors limited access to startup equity.

Real Estate

Real estate investments have become incredibly popular with the surge in short-term rental properties and can include whole properties or fractional ownership. Real estate can also include land investments, with farmland, in particular, emerging as an increasingly popular alternative investment class.

• Risks: Market volatility, illiquidity, property depreciation, tenant risks, regulatory changes, and leverage-related risks.
• Eligibility: Direct property investment does not require accreditation, but some real estate platforms have accreditation requirements.

Crypto and Digital Assets

Cryptocurrencies such as Bitcoin, and digital assets such as NFTs (non-fungible tokens) are a relatively new class of alternative investments that have become easily available to both accredited and retail investors through online platforms such as Coinbase and OpenSea.

• Risks: High volatility, regulatory uncertainty, cybersecurity risks (hacks, fraud), loss of private keys, and tax complexity.
• Eligibility: Retail investors can purchase digital assets without accreditation, though some advanced products may have restrictions.

Collectibles

Artwork, vintage cars, fine wine, and other physical goods and memorabilia are some of the more unique types of alternative investments. With supply inherently limited for many of these assets, fractional-ownership platforms such as Masterworks and Rally Rd exist to help investors access the collectibles market.

• Risks: Illiquidity, subjective valuation, authenticity risks, fraud risks, market demand fluctuations, and high transaction costs.
• Eligibility: No accreditation requirement, but investment platforms may impose minimum investment thresholds.

Hedge Funds

Hedge funds are investment funds that pool money from accredited investors to employ advanced strategies, such as short selling, derivatives, and leverage, in order to generate returns that may not correlate with the broader market. Often less liquid and requiring larger capital commitments, hedge funds charge higher fees and are known for more complex tax and reporting requirements.

• Risks: High fees, complex tax structures, performance variability, use of leverage, lock-up periods, and regulatory differences.
• Eligibility: Typically requires accredited investor or qualified client status due to regulatory restrictions.

Credit Funds

Credit funds specialize in investing in private debt, including corporate loans, distressed debt, and mezzanine financing. They provide alternative financing for companies and typically offer higher yields than traditional bonds, albeit with increased risk. Credit funds also tend to have longer holding periods and unique tax considerations.

• Risks: Credit risk, interest rate fluctuations, illiquidity, economic downturn exposure, and reliance on the fund manager’s expertise.
• Eligibility: Usually limited to accredited investors and qualified purchasers.

How Are Alternative Investments Taxed?

Unlike traditional stocks and bonds, alternative investments are subject to unique tax rules, reporting requirements, and varying tax rates. Below is a breakdown of the primary tax considerations for different alternative asset classes.

Private Equity & Venture Capital Taxation

Private equity and venture capital investments are typically structured as limited partnerships (LPs) or limited liability companies (LLCs). This means investors generally receive a Schedule K-1, which reports their share of the fund’s income, deductions, and credits.

• Capital Gains: Profits from selling private equity or venture capital investments are taxed as capital gains—short-term (ordinary income rates) if held for less than a year, long-term (0%, 15%, or 20%) if held longer.
• Carried Interest (For Fund Managers Only): Fund managers may receive a share of profits taxed at long-term capital gains rates instead of ordinary income rates. This does not apply to typical investors.
• Qualified Small Business Stock (QSBS) Exemption (Niche Scenario): Certain startup shares may qualify for the QSBS exemption, allowing up to 100% of capital gains if held for at least five years.

See our complete guide to venture capital, private equity, and angel investment taxation.

Real Estate Investment Taxation

Real estate investments have the potential to generate rental income, appreciation, and tax benefits, but tax treatment varies depending on how the property is used.

• Rental Income: Taxed as ordinary income, but depreciation deductions can reduce taxable income.
• Capital Gains on Sale: Profits from selling real estate are taxed as long-term capital gains if held for more than a year.
• Depreciation Recapture: If a property is sold for more than its depreciated value, a portion of the gain is taxed at a higher 25% rate.
• Short-Term Rental Taxation: If a property is rented for seven days or less per stay, the IRS classifies the income as business income, subjecting it to self-employment taxes.

 

Cryptocurrency & Digital Asset Taxation

Cryptocurrencies are treated as property for tax purposes, meaning every transaction has potential tax consequences.

• Capital Gains: Profits from selling or trading crypto are taxed as short-term or long-term capital gains, depending on the holding period.
• Mining & Staking Income: Earnings from crypto mining or staking are taxed as ordinary income and may be subject to self-employment tax.
• Taxable Transactions: Exchanging one cryptocurrency for another, using crypto for purchases, or earning crypto rewards all trigger taxable events.

See our complete guide to crypto taxation.

Collectibles & Fine Art Taxation

Collectibles, including fine art, antiques, and other rare items, have a unique tax structure compared to other investments.

• Higher Capital Gains Tax Rate: Long-term gains from collectibles are taxed at 28%, higher than the maximum 20% rate for stocks and real estate.
• Charitable Donations: Donating collectibles to a qualified nonprofit can provide tax deductions based on fair market value.
• Estate & Inheritance Considerations: Collectibles passed to heirs receive a step-up in basis, eliminating capital gains accrued during the original owner’s lifetime.

Hedge Fund Investor Taxation

Hedge fund taxation depends on the investment strategy and structure of the fund.

• K-1 Reporting: Like private equity, hedge fund investors often receive Schedule K-1s to report their share of fund income and losses.
• Unrelated Business Taxable Income (UBTI): Investors holding hedge funds in tax-advantaged accounts (IRAs, 401(k)s) may face unexpected UBTI taxes.
• Net Investment Income Tax (NIIT): Investors earning passive income from hedge funds may be subject to an additional 3.8% NIIT tax.

What Are the Tax Strategies for Alternative Investments?

Tax-efficient investing in alternative assets requires proactive planning to minimize tax liabilities and maximize after-tax returns. Below are key strategies investors can use to potentially optimize their tax position when investing in alternative assets.

Tax Deferral Strategies

Some alternative investment structures allow investors to defer taxes on gains or income, delaying tax payments until a future date.

• 1031 Exchanges (Real Estate): Investors can defer capital gains taxes by reinvesting proceeds from the sale of an investment property into a like-kind property within 180 days.
• Qualified Opportunity Zones (QOZs): Capital gains can be deferred and partially reduced when reinvested in QOZ funds, with the possibility of full tax exemption on future appreciation after 10 years.
• Carried Interest (Private Equity & Hedge Funds): Private equity and hedge fund managers benefit from carried interest, allowing their earnings to be taxed at lower long-term capital gains rates instead of ordinary income rates.
• Private Placement Life Insurance (PPLI): High-net-worth investors can use PPLI to defer taxes on gains from alternative investments. PPLI also provides the opportunity for tax-free compounding within the policy, as long as funds remain invested.

Reducing Taxable Income with Deductions

Certain deductions can help offset taxable income, reducing the total amount owed to the IRS.

• Depreciation (Real Estate & Farmland): Rental properties and farmland investors can claim annual depreciation deductions, lowering taxable rental income.
• Investment-Related Expenses: Fees paid for investment advisory services, fund management, and tax preparation may be deductible.
• Charitable Contributions (Fine Art & Collectibles): Donating appreciated assets to qualified charities can result in a fair market value deduction while avoiding capital gains taxes.

Strategies to Lower Capital Gains Taxes

Capital gains taxes can significantly impact investment returns, but strategies exist to reduce or eliminate them.

• Tax-Loss Harvesting (Crypto, Stocks, & Funds): Investors can offset realized capital gains by selling underperforming assets at a loss. Losses exceeding gains can be carried forward indefinitely.
• Qualified Small Business Stock (QSBS) Exemption (Venture Capital & Private Equity): Under Section 1202, investors in eligible startup shares may exclude up to 100% of capital gains if the shares are held for at least five years.
• Step-Up in Basis (Estate Planning for Alternative Investments): When heirs inherit alternative investments, the cost basis is ‘stepped up’ to the fair market value at the time of the original owner’s death, eliminating any unrealized capital gains.

Managing Passive Investment Income Taxes

Passive income from alternative investments may be subject to additional taxes, requiring proactive management.

• Net Investment Income Tax (NIIT): A 3.8% tax applies to passive income over $200,000 for individuals ($250,000 for couples), impacting real estate, private equity, and hedge funds.
• Unrelated Business Taxable Income (UBTI) (Hedge Funds & IRAs): Some hedge funds generate UBTI, which can trigger taxes within tax-advantaged accounts like IRAs.
• Short-Term Rental Taxation (Real Estate): Rental income from properties with an average stay of 7 days or less may be classified as active business income, subject to self-employment taxes.

How Do I Invest in Alternative Investments?

Investing in alternative assets requires a different approach than investing in traditional stocks and bonds. Below are the key steps to accessing and investing in alternative assets.

Determine If You Qualify as an Accredited Investor

Many alternative investments, including private equity, hedge funds, and venture capital, require investors to be accredited before they can participate. To qualify as an accredited investor in 2025, you must meet one of the following criteria:

• Income Requirement: Earn at least $200,000 per year ($300,000 with a spouse or domestic partner) for the past two years, with expectations of the same for the current year.
• Net Worth Requirement: Have a net worth exceeding $1 million, excluding your primary residence.
• Financial Professional Qualification: Holding certain financial licenses, such as Series 7, 65, or 82, may also grant accreditation status.

If you are not an accredited investor, your options for alternative investments may be more limited, but some platforms offer fractional ownership and lower investment minimums to make alternative assets more accessible.

Choose the Right Investment Platform

Below are some platforms to consider for different alternative asset types:

• Private Equity & Venture Capital: iCapital, AngelList, Hiive
• Real Estate & Farmland: FarmTogether, Fundrise, Crowdstreet
• Hedge Funds & Managed Strategies: Arta, iCapital, Yieldstreet
• Collectibles & Fine Art: Masterworks, Rally Rd
• Crypto & Digital Assets: Coinbase, OpenSea, Gemini

Each alternative investment platform has different investment minimums, fee structures, and liquidity options, so it is essential to carefully evaluate all options before committing capital.

Understand Liquidity and Exit Strategies

Alternative investments are often illiquid, meaning they cannot be easily sold or converted into cash like stocks. Before investing in alts, consider:

• Lock-Up Periods: Some investments require multi-year commitments, particularly hedge funds and private equity, which in some cases can require 5-10+ years before capital can be withdrawn.
• Secondary Markets: Some platforms, such as Hiive, provide secondary markets where investors and startup employees can sell private shares without needing to wait for tender offers or other major liquidity events.
• Redemption Restrictions: Hedge funds and private equity funds may only allow withdrawals at specific intervals, such as quarterly or annually.

Evaluate Fees and Tax Considerations

Alternative investments can come with higher fees and complex tax implications compared to traditional stocks and ETFs. Be mindful of:

• Management Fees: Private equity and hedge funds often charge an annual management fee of 1-2%, which covers operational expenses.
• Performance Fees: Hedge funds and some private equity firms charge a “2 and 20” structure (2% management fee + 20% of profits). These performance fees are also known as carried interest, or “carry.”
• Pass-Through Expenses: Investors in pooled investment vehicles, such as hedge funds and private equity funds, may also incur additional expenses passed through from the fund. These include legal fees, administrative costs, audit expenses, compliance costs, and operational fees. These costs are typically outlined in the fund’s Private Placement Memorandum (PPM) or offering documents.
• Fund Expenses: Some funds pass through costs related to third-party services such as due diligence, marketing, custodial services, and fund administration.
• Tax Complexity: Many alternative investments issue Schedule K-1s instead of Form 1099, meaning investors may face additional tax reporting requirements, potential delays in tax filings, and increased preparation costs..

Carefully reviewing offering documents, including the PPM, and consulting with financial and tax advisors can help investors better understand the fee structures and tax implications before committing capital to alternative investments.

Work with an Experienced Tax Advisor

Due to the unique tax treatment and reporting complexities of alternative investments, working with a tax professional experienced in alternative assets can help you optimize your investment strategy.

A qualified tax advisor can help you:

• Navigate complex tax reporting requirements, including K-1 forms for private equity, hedge funds, and real estate partnerships.
• Minimize tax liabilities through strategies such as tax-loss harvesting, 1031 exchanges, and proper entity structuring.
• Navigate compliance with capital gains tax rules for alternative assets, including collectibles, crypto, and private investments.

Harness can help you find tax advisors experienced in alternative investments and other complex areas to help you achieve your financial goals.

 

Frequently Asked Questions (FAQs)

Below are some of the most frequently asked questions about alternative investments.

What are alts?

Alternative investments refer to non-traditional assets such as private equity, real estate, hedge funds, fine art, collectibles, and cryptocurrencies. Alts can potentially provide diversification and higher returns but can also be less liquid and often require specialized tax treatment.

How are alts taxed?

Tax treatment varies by asset class. Private equity and venture capital investments are taxed as capital gains and often involve Schedule K-1 reporting. Real estate investors benefit from depreciation deductions and 1031 exchanges. Hedge funds may generate taxable K-1 income, and some may trigger Unrelated Business Taxable Income (UBTI) in IRAs. Cryptocurrency transactions are taxable events, and collectibles are subject to a higher capital gains tax rate of 28%.

Do I need to be an accredited investor to invest in alts?

Many—but not all—alternative investments require accreditation. To qualify as an accredited investor, you must have an annual income of at least $200,000 ($300,000 with a spouse) for two consecutive years or a net worth exceeding $1 million (excluding your primary residence).

What tax forms do alternative investments require?

Unlike traditional investments that issue Form 1099s, alternative investments often require additional documentation such as Schedule K-1 (for partnerships, hedge funds, and private equity), Schedule K-3 (for foreign tax reporting), Form 8949 (for capital gains and losses), and Form 8283 (for charitable donations of collectibles or artwork).

Can I hold alternative investments in my retirement accounts?

Alternative investments can be held in self-directed IRAs (SDIRAs) or certain 401(k) plans, investors can hold private equity, real estate, hedge funds, and cryptocurrency. However, some alternative investments may generate UBTI, which could trigger unexpected taxes within tax-advantaged accounts.

What are the biggest risks of alternative investments?

Alternative investments can potentially have long holding periods, limited liquidity, and higher fees. Their valuations can be uncertain since they are not traded on public markets. Additionally, complex tax implications and potential estate planning challenges should be considered before investing.

How can I reduce taxes on my alternative investments?

Tax optimization strategies can include tax-loss harvesting for crypto and stocks, 1031 exchanges for real estate, QSBS exemptions for private equity, and step-up in basis provisions for inherited assets. Working with a tax advisor can help structure investments efficiently.

How can I get started with alternative asset investing?

Determine if you qualify as an accredited investor, select the right platform based on investment goals, understand liquidity and fees, and consult a tax advisor to ensure compliance and tax efficiency.

 

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All investments and investment strategies have the potential for profit or loss. There can be no assurance that any specific investment or strategy will be profitable. Different types of investments involve varying degrees of risk. Past performance may not be indicative of future results.

Alternative Investment Risks: Alternative investments provide limited liquidity and include, among other things, the risks inherent in investing in real estate, securities and derivatives, using leverage and engaging in short sales. An investment in an alternative investment fund is speculative, involves substantial risks, and should not constitute a complete investment program. An alternative investment fund may be highly leveraged. The volatility of the price of its interests may involve complex tax structures and there may be delays in distributing important tax information. These funds may not be subject to the same regulatory requirements as mutual funds, and their fees and expenses may be high. An investment in alternative investments is not suitable or desirable for all investors. Investors may lose all or a portion of the capital invested.