Carried interest has been taxed as capital gains rather than ordinary income for decades, but the rules have tightened. Under current tax law, carried interest gains are treated as long-term capital gains only if the fund holds the underlying investment for more than three years. If the holding period is three years or less, gains allocated as carry are recharacterized as short-term capital gains, taxed at ordinary income rates.
How Section 1061 Works
Section 1061 of the Internal Revenue Code, enacted as part of the Tax Cuts and Jobs Act of 2017, imposes a three-year holding period requirement on gains from "applicable partnership interests" (APIs). An API is any partnership interest received in connection with the performance of services in an investing or trading activity. Carried interest in a private fund is the most common example.
- If the fund holds an investment for more than three years, the carry allocated from that investment qualifies for the long-term capital gains rate of 20%, plus the 3.8% Net Investment Income Tax (NIIT), for a combined rate of 23.8%
- If the fund holds an investment for three years or less, the carry is recharacterized as short-term capital gain, taxed at ordinary income rates of up to 37%, plus the 3.8% NIIT, for a combined rate of up to 40.8%
- The holding period clock starts when the fund acquires the investment, not when the GP began earning carry
The difference between 23.8% and 40.8% is substantial. On $10 million of carry, the tax differential is approximately $1.7 million. This makes holding period tracking at the investment level an essential part of fund tax planning.
Who Is Affected
Section 1061 applies to fund managers, not LPs. An LP's return on investment is based on the fund's actual holding period for each investment, without the three-year overlay. If the fund holds an investment for 18 months and sells at a gain, the LP reports a short-term capital gain. The GP reports the same gain as short-term as well, but under Section 1061 this treatment applies regardless of when the GP's carry vested or when the GP made its capital commitment.
The statute specifically targets the profit allocation received by the GP for investment management services. It does not affect the GP's return on its own invested capital (the GP commit), which is treated like any other LP interest.
Planning Considerations
The practical impact of Section 1061 varies significantly by fund strategy:
- Venture capital funds typically hold portfolio companies for five to ten years before exit. For most VC investments, the three-year requirement is met without any change in behavior, making Section 1061 largely irrelevant to VC carry.
- Private equity and growth equity funds may hold investments for three to seven years. Some exits, particularly early-stage partial liquidity events or portfolio rebalancing, may fall within the three-year window and trigger recharacterization.
- Hedge funds and short-duration strategies are the most affected. Strategies that regularly trade positions within three years will see the majority of carry taxed at ordinary income rates.
- Real estate funds with shorter hold periods or value-add strategies that target two-to-four-year exits should track holding periods at the property level.
Fund managers should track holding periods at the individual investment level throughout the fund's life. This data is needed not only for tax compliance but also for GP tax planning and carry modeling.
Reporting and Compliance
Section 1061 gains are reported on the fund's partnership tax return and flow through to the GP's K-1. The tax preparer must separately identify gains from applicable partnership interests and apply the three-year holding period test to each investment exit during the year.
- The fund's tax return must include Schedule 1061, which separates gains on investments held more than three years from gains on investments held three years or less
- The GP reports Section 1061 recharacterized amounts on their personal return using Form 8949 and Schedule D
- Tax preparers must have access to detailed acquisition dates and disposition dates for each portfolio investment to apply the holding period test accurately
This article is for informational purposes only and does not constitute legal or tax advice. Consult qualified professionals for guidance specific to your situation.