The carried interest tax break lets private equity, venture capital, and hedge fund managers pay a top federal rate of 20% on their share of fund profits instead of the 37% top rate that applies to ordinary income. On every dollar of profit share, that saves up to 17 cents in federal tax. The break survives intact for 2026, though it now comes with a three-year holding period that didn’t exist before 2018.
What Carried Interest Actually Is
Carried interest is a fund manager’s cut of investment profits. Outside investors (limited partners) put up nearly all the money. The manager (the general partner) runs the fund and contributes a relatively small amount of capital. Once investors get their money back plus a minimum return, usually around 8%, the manager takes roughly 20% of what’s left. That 20% profit share is the carried interest.
It isn’t a salary and it isn’t guaranteed. If the fund loses money, the manager’s carry is worth nothing. That risk-and-reward structure is the foundation for the way it’s taxed, and the reason repeal has been politically difficult.
Why the Rate Is So Low
Investment funds are almost always organized as partnerships, and partnerships don’t pay tax themselves. Income passes through to each partner and keeps the character it had inside the fund. When the fund sells an investment it held for years at a profit, that profit is a long-term capital gain. When 20% of it is allocated to the manager, it lands on the manager’s return still classified as a long-term capital gain.
Long-term capital gains top out at a 20% federal rate for high earners. In 2026 that rate applies to single filers with taxable income above $545,500 and joint filers above $613,700; below those thresholds the rate is 15% or 0%.1Internal Revenue Service. Topic No. 409, Capital Gains and Losses Ordinary income runs up to 37%, which starts at $640,600 for single filers and $768,700 for married couples filing jointly in 2026.2Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026 The gap between those two top rates is the break.
Critics say the profit share is really compensation for services and should be taxed like any other professional’s earnings. Defenders say the manager is a co-investor whose return depends entirely on performance, closer to entrepreneurial risk than a paycheck. The debate has run for decades without resolution.
The Three-Year Holding Period
Before 2018, a fund only needed to hold an investment for just over a year for the manager’s profit share to qualify for long-term capital gains rates, the same as any other capital asset. The Tax Cuts and Jobs Act tightened that. Section 1061 of the Internal Revenue Code now requires the fund to have held the underlying asset for more than three years before the manager’s share qualifies for the 20% rate.3Office of the Law Revision Counsel. 26 USC 1061 – Partnership Interests Held in Connection With Performance of Services
If the fund sells an investment at the two-year mark, the manager’s share of that gain is recharacterized as short-term capital gain and taxed at ordinary rates up to 37%. What matters is how long the fund held the asset, not how long the manager has been a partner.3Office of the Law Revision Counsel. 26 USC 1061 – Partnership Interests Held in Connection With Performance of Services
The three-year rule bites hardest on hedge funds and strategies that trade more actively. Traditional private equity and venture capital funds usually hold portfolio companies for five to seven years, so most of their exits clear the threshold easily.
What the Rule Covers, and What It Doesn’t
Section 1061 applies to “applicable partnership interests,” meaning interests held in connection with substantial services in an “applicable trade or business.” That business has to involve raising or returning capital and investing in “specified assets.”3Office of the Law Revision Counsel. 26 USC 1061 – Partnership Interests Held in Connection With Performance of Services
Specified assets include securities, commodities, real estate held for rental or investment, cash equivalents, options, derivatives, and partnership interests to the extent they hold any of the above.3Office of the Law Revision Counsel. 26 USC 1061 – Partnership Interests Held in Connection With Performance of Services That reaches private equity, venture capital, hedge funds, real estate investment funds, and commodity funds. It does not reach operating businesses that happen to be partnerships, such as a law firm or restaurant group, because those aren’t in the business of investing in specified assets for outside investors.
Two exceptions pull certain interests out of the three-year rule even inside investment partnerships:
- Interests held by a corporation. If a manager holds the interest through a C corporation, Section 1061 doesn’t apply. In practice the corporate layer creates its own tax cost, so this route has limited appeal.3Office of the Law Revision Counsel. 26 USC 1061 – Partnership Interests Held in Connection With Performance of Services
- Capital interests commensurate with contributions. If a manager puts in actual money and gets a return proportional to that contribution, treated the same as other investors putting in similar amounts, that piece of the interest is not an applicable partnership interest. The partnership has to keep contemporaneous records separating allocations on contributed capital from allocations on the carry, or the IRS can treat the whole interest as subject to the three-year rule.3Office of the Law Revision Counsel. 26 USC 1061 – Partnership Interests Held in Connection With Performance of Services4eCFR. 26 CFR 1.1061-3 – Exceptions to the Definition of an API
The capital interest exception matters because many managers invest personal money alongside their investors. A manager who puts in $5 million next to $500 million of outside capital can separate the returns on that $5 million from the carry and run those returns under the ordinary one-year holding period for capital gains.
Other Taxes That Can Reduce the Savings
Net Investment Income Tax
A 3.8% net investment income tax applies to investment income above $200,000 for single filers and $250,000 for married couples filing jointly. Those thresholds are not indexed for inflation and have been the same since the tax took effect in 2013.5Internal Revenue Service. Questions and Answers on the Net Investment Income Tax At first glance that would push the effective top rate on carry to 23.8%.
Most active fund managers are probably outside its reach. The NIIT excludes income from a trade or business in which the taxpayer materially participates, and a general partner actively managing a fund’s investments almost certainly qualifies. IRS guidance confirms that operating income from a nonpassive business isn’t net investment income.5Internal Revenue Service. Questions and Answers on the Net Investment Income Tax Passive investors in the fund, or managers with minimal day-to-day involvement, can still owe the extra 3.8%.
Self-Employment Tax
Self-employment tax funds Social Security and Medicare at a combined 15.3% on income up to the Social Security wage base, with the 2.9% Medicare portion continuing on all earnings. Section 1402(a)(13) generally excludes a limited partner’s distributive share from self-employment tax, though guaranteed payments for services remain taxable.6Office of the Law Revision Counsel. 26 U.S. Code 1402 – Definitions Fund managers have long relied on that exclusion to keep carry out of self-employment tax.
The Tax Court’s 2023 decision in Soroban Capital Partners LP v. Commissioner made that reliance shakier. The court held that partners who actively participate in a partnership’s business may not qualify as “limited partners, as such” for purposes of the exemption, regardless of state-law title. Partners who provide significant services to a fund could face self-employment tax on at least part of their partnership income. The full implications are still working themselves out.
Where Reform Stands
Carried interest has been a target for both parties for over a decade. The three-year holding period came in with the Tax Cuts and Jobs Act. A 2022 attempt to tighten the rules further was stripped out of the Inflation Reduction Act in final negotiations.
The Carried Interest Fairness Act was introduced in February 2025 and would tax carry at ordinary income rates. Its sponsors estimate a $6.5 billion increase in revenue over ten years. The One Big Beautiful Bill Act, which extended TCJA’s individual provisions through 2028, left carried interest untouched. For 2026, the three-year holding period and the underlying capital gains treatment both stand.