Carried Interest — Section 1061 and the Three-Year Holding Period Rule for Fund Managers
Private equity fund managers, venture capitalists, and hedge fund portfolio managers receive a share of the fund's profits — called "carried interest" — as compensation for managing investors' money. For decades, the IRS treated that profit share as long-term capital gain taxed at 20% (plus the 3.8% net investment income tax), even though it was economically compensation for services. Congress drew a partial line in the Tax Cuts and Jobs Act of 2017. See Long-Term Capital Gains for the rate structure and Partnership Tax Rules for how fund income flows to partners. Congress drew a partial line in the TCJA by enacting Section 1061, which requires fund managers to hold their partnership interests for more than three years — not the standard one year — before gains on those interests qualify for long-term capital gain rates. Profits realized within three years are recharacterized as short-term capital gain, taxed at ordinary income rates up to 37%. The rule applies to "applicable partnership interests" held in connection with services in "applicable trades or businesses" — which means private equity, venture capital, real estate funds, and hedge funds are all in scope. It does not eliminate the carried interest benefit entirely; it extends the required holding period and catches managers who flip their interests or realize gains quickly.
Current Law (2026)
| Parameter | Value |
|---|---|
| Core statute | 26 U.S.C. § 1061 |
| Enacted | Tax Cuts and Jobs Act of 2017 |
| Who it applies to | Fund managers holding "applicable partnership interests" — interests received in exchange for services in raising/investing capital |
| Holding period required | More than 3 years (vs. the standard 1-year for long-term capital gain) |
| Effect of shorter hold | Net long-term capital gain on the interest is recharacterized as short-term capital gain (taxed at ordinary rates, up to 37%) |
| Applicable trades or businesses | Raising or returning capital AND investing in/developing "specified assets" — securities, commodities, real estate held for investment, derivatives |
| Excludes | Interests held by corporations; capital interests proportionate to actual capital contributed; interests previously included in income under § 83 |
| Related-party rule | Transfers to related parties also subject to 3-year holding test — can't reset clock by gifting |
| Not covered | Carried interests in real estate funds where gains are from § 1231 property (some planning opportunities remain) |
| IRS regulations | Final regulations issued Jan. 2021 (T.D. 9945) clarifying gain allocation and passthrough rules |
Legal Authority
- 26 U.S.C. § 1061(a) — The recharacterization rule: if a taxpayer holds one or more "applicable partnership interests" at any time during the year, the excess of net long-term capital gain over net long-term capital gain computed using a 3-year threshold is recharacterized as short-term capital gain — taxed at ordinary rates
- 26 U.S.C. § 1061(b) — Portfolio investment carve-out: the Secretary may provide that § 1061 does not apply to income or gain from assets not held for portfolio investment on behalf of third-party investors — preserving the distinction between fund management (covered) and operating businesses (not covered)
- 26 U.S.C. § 1061(c)(1) — "Applicable partnership interest" definition: any interest in a partnership transferred to (or held by) the taxpayer in connection with the performance of substantial services in an applicable trade or business; excludes interests held by corporations and interests commensurate with capital contributed
- 26 U.S.C. § 1061(c)(2) — "Applicable trade or business" definition: a regular, continuous, substantial activity consisting of raising or returning capital AND either (i) investing in/disposing of specified assets, or (ii) developing specified assets — this covers PE, VC, real estate funds, and hedge funds
- 26 U.S.C. § 1061(c)(3) — "Specified assets" definition: securities, commodities, real estate held for rental or investment, cash or cash equivalents, options or derivative contracts — the asset classes that fund managers typically trade or invest in
- 26 U.S.C. § 1061(c)(4) — Capital interest exclusion: interests that provide a right to share in partnership capital commensurate with capital contributed (at time of receipt) or with value taxed under § 83 at receipt/vesting are not "applicable partnership interests" — meaning co-investment capital alongside the fund's LPs is not affected
How Carried Interest Works
"Carried interest" is the fund manager's share of investment profits above a preferred return threshold. A typical private equity structure might look like: LPs put up 99% of the capital, GPs (fund managers) put up 1%; but if the fund returns more than an 8% hurdle rate, the GPs receive 20% of all additional profits — their "carry." For a $1 billion fund that returns 2×, the LPs' profit is roughly $800M and the GPs' carry is roughly $200M.
Before § 1061, the entire $200M gain was long-term capital gain if the fund held assets for more than one year — taxed at 20% plus the 3.8% NIIT, for a combined 23.8% rate. This was vastly more favorable than ordinary income rates of 37% plus 2.9% Medicare tax (or 3.8% NIIT).
What § 1061 changed: The hold period to get that favorable rate is now three years, not one. If a fund manager receives carry distributions on assets sold within three years, the carry is recharacterized as short-term gain taxed at up to 37%. This significantly affects:
- Hedge funds with short-term trading strategies — managers rarely hold positions more than a year, so much of their carry is already short-term; § 1061 adds a second threshold for any medium-term positions
- Early-stage VC funds that may have liquidity events in companies held 2–3 years rather than the typical 7–10 year PE hold
- Real estate funds with value-add strategies that buy, renovate, and sell properties on a 2–3 year timeline
What § 1061 did not change: The core carried interest preference remains intact for fund managers whose underlying assets are held for more than 3 years. Long-term PE funds holding portfolio companies for 5–7 years before exit are largely unaffected by § 1061 — the carry on those exits still qualifies for capital gain rates.
Planning Considerations
The related-party transfer rule prevents fund managers from gifting or transferring carried interests to family members or related entities to reset the clock or shift income to lower-bracket taxpayers. The 2021 Treasury regulations (T.D. 9945) clarified that transfers of applicable partnership interests to related parties trigger the same recharacterization.
Corporation exclusion: § 1061(c)(4)(A) excludes interests held by corporations from the applicable partnership interest definition. This created planning opportunities where fund managers interposed C corporations between themselves and the fund — the interest held by the corporation is not an API. Treasury regulations addressed and partially limited this approach.
Capital interest vs. carried interest: Fund managers who co-invest their own capital alongside LPs receive a "capital interest" proportionate to their contribution. That capital interest is excluded from § 1061 — only the promoted/carried interest (the economic uplift above their pro-rata share) is subject to the three-year rule. Careful tracking of capital interest vs. profits interest allocations is required.
§ 1231 real estate exception: Gain from § 1231 property (business real estate) may not be fully subject to § 1061's recharacterization in certain circumstances — the gain is § 1231 gain first, which is treated separately from capital gain in the § 1061 calculation. This area remains complex and contested.
How It Affects You
If you manage a private equity fund, real estate fund, or venture fund: You need per-investment tracking of the date each asset was acquired by the fund — a portfolio-level average doesn't satisfy § 1061. Maintain a position-by-position log recording acquisition date, exit date, days held, and the gain allocable to your carry on each exit. Under § 1061, carry allocable to assets held three years or less is recharacterized as short-term capital gain taxed at up to 37%, while carry on assets held more than three years retains long-term capital gain treatment at 20% (plus 3.8% NIIT). Critically, also track your capital interest separately from your carried interest (profits interest). Under § 1061(c)(4)(B), gains allocated to a partnership interest proportionate to capital you actually contributed are not applicable partnership interests and escape § 1061 entirely. For a GP who contributed $1 million to a $100 million fund, approximately 1% of gains flowing to you are capital-interest gains (exempt), with the remaining 19% of gains being carry (subject to § 1061). Clean fund accounting records tied to each partner's capital account are required to document this split. Work with fund counsel to confirm that the 2021 final Treasury regulations (T.D. 9945) are properly implemented in your fund agreements, particularly for tiered structures (master-feeder, fund-of-funds) where § 1061 applies at each level.
If you're a hedge fund manager: Most of your trading book already generates short-term capital gain regardless of § 1061 — positions held under one year were already taxed at ordinary rates before § 1061 existed. The recharacterization rule bites on medium-duration positions held 13–35 months: these would have qualified for long-term capital gain under the standard 1-year rule, but § 1061 recharacterizes them as short-term because they fall short of the 3-year threshold. If you hold equity, credit, or convertible positions on a 2–3 year investment thesis, model the § 1061 impact in Q4 as positions approach the 3-year mark. An exit in month 35 at a higher price may net less after tax at 37% than a slightly lower price at month 37 taxed at 23.8%. Track each position's acquisition date in your tax reporting system — learning about API recharacterization from a K-1 in March is avoidable.
If you're an LP (limited partner) in a private equity fund: Section 1061 does not affect your investment returns. The applicable-partnership-interest rules apply only to interests received in connection with performing services — your LP interest reflects capital you invested, not services you rendered. Your capital gains are determined by the fund's holding periods for its portfolio investments in the normal way: long-term gain if the fund held an asset more than one year, short-term if less. The managers' § 1061 recharacterization on their carry doesn't change what flows to you on your Schedule K-1. The one tax complexity for LPs in global PE or VC funds is if the fund holds shares in PFIC (passive foreign investment company) entities — that creates separate reporting obligations independent of § 1061.
If you're structuring new fund vehicles or GP economics: The capital interest exception under § 1061(c)(4)(B) is the primary structuring target. Requiring GPs to make a meaningful co-investment at fund formation — sized so their economic interest is proportionate to their capital contribution, not just their promoted interest — creates a documented capital interest that escapes § 1061 on all gains attributable to that invested capital. Profits interests granted under Revenue Procedure 93-27 (no income inclusion at grant, zero liquidation value at issuance) remain the standard mechanism for conveying carried interest; track the original grant date carefully, as any modification that changes the character of the interest can restart holding periods. Treasury issued proposed regulations in 2020 that would tighten several structuring approaches — including the C corporation exception, where some managers interposed a corporate blocker to hold the carried interest outside the API definition — and while those proposed rules haven't been finalized as of 2026, monitor their finalization before relying on structures they would limit. Engage a fund tax attorney to review your fund agreement's carried interest and capital interest definitions against T.D. 9945 before closing your next fund.
State Variations
California taxes all capital gains as ordinary income, so § 1061's federal recharacterization has minimal additional impact for California-resident fund managers — they were already paying 13.3% state tax on capital gains. New York imposes ordinary income tax on short-term gains and a somewhat lower rate on long-term capital gains for New York City residents, making the federal recharacterization more meaningful there. Most states conform to federal capital gain vs. ordinary income characterization.
Pending Legislation
Proposals to eliminate the carried interest preference entirely — taxing all fund manager carry as ordinary income regardless of holding period — have been introduced in multiple Congresses and are part of ongoing Democratic tax reform proposals. The 3-year holding period in § 1061 was itself a compromise from proposals that would have fully eliminated the preference. Further extension of the holding period to 5 or 7 years, or elimination of the preference altogether, remains a recurring policy debate. No major changes advanced in 2024–2025.
Recent Developments
Treasury finalized comprehensive § 1061 regulations in January 2021 (T.D. 9945), clarifying: (1) how gain is allocated among partnership interests in tiered fund structures; (2) the treatment of API transfers to related parties; (3) how the corporation exclusion interacts with fund manager structuring; and (4) the interaction with § 1231 gains. The regulations confirmed that Qualified Opportunity Zone gains treated as deferred § 1231 gain may be affected by § 1061 when the deferral period ends, which created planning considerations for fund managers with QOZ investments.
- OBBBB reconciliation — carried interest survives again (2025-2026): Despite perennial bipartisan criticism, the carried interest preference was not included in the "One Big Beautiful Bill Act" reconciliation package. Trump had previously expressed support for eliminating the "hedge fund loophole" but reversed position after industry lobbying. The private equity and hedge fund industries contributed heavily to Republican congressional campaigns; carried interest repeal was dropped from the reconciliation package early in the process. The preference has survived every tax reform effort since 2007 despite polling as broadly unpopular across party lines.
- Fund manager planning around § 1061: Since the § 1061 regulations were finalized, fund managers have adapted structuring to minimize the API reclassification. Common approaches include: holding assets longer than 3 years to escape API treatment entirely; structuring around the "capital interest" exception (gains allocated to a fund manager's invested capital rather than promote are not subject to § 1061); and using the corporation exception for certain fund structures. Family office and fund-of-funds structuring remains complex under the tiered entity rules.
- State tax treatment of carried interest: Several blue states — California, New York, New Jersey — have proposed or enacted state-level carried interest restrictions that are independent of § 1061. New York enacted a bill in 2021 that would have taxed carried interest as ordinary income at the state level, but it included an effective-date trigger requiring neighboring states to enact similar legislation (to prevent fund manager migration) that was never met. California has introduced similar legislation in multiple sessions. State-level actions could accelerate fund manager relocation decisions.
- Private equity political economy: The private equity industry's political spending has increased dramatically in recent election cycles, with PE-affiliated PACs and executives among the largest donors to both parties. The industry's lobbying success on carried interest preservation is one of the clearest examples of concentrated-interest politics overriding broad public preferences. CBO has estimated carried interest repeal would raise $14-16 billion over 10 years — meaningful in the context of OBBBB's pay-for requirements.