Carried interest is taxed as capital gains if the fund holds the underlying investment long enough. Under Section 1061, the holding period for carry recipients is three years, not the standard one year for regular investors.
The Short Answer
If the fund holds an investment for more than three years, carry is taxed at long-term capital gains rates (20% plus 3.8% NIIT). If the holding period is three years or less, carry is taxed at ordinary income rates (up to 37% plus NIIT). LP returns are not affected by Section 1061; the three-year rule applies only to the GP's carried interest allocation.
How It Works
- Holding period over three years: Carry taxed at long-term capital gains rates (20% + 3.8% NIIT).
- Holding period three years or less: Carry recharacterized as short-term and taxed at ordinary income rates (up to 37% + NIIT).
- LP returns: Not affected by Section 1061. LPs qualify for long-term treatment after the standard one-year holding period.
- Per-investment basis: The three-year test applies to each investment separately, not the fund as a whole.
Impact by Strategy
VC funds typically hold investments well beyond three years, so carry usually qualifies for long-term treatment. PE buyout funds with shorter hold periods may see some investments fall below the three-year threshold. Hedge funds with short holding periods are most affected, as much of their carry may be recharacterized as ordinary income.
This content is for informational purposes only and does not constitute legal, tax, or compliance advice. Consult qualified counsel for guidance specific to your situation.