Carried interest tax reform centers on a single gap: fund managers can pay a 20% long-term capital gains rate on their share of investment profits, while the top ordinary income rate reaches 37% and is scheduled to return to 39.6%. Federal law today requires the fund to hold its assets more than three years before the manager’s share qualifies for the lower rate, and proposals in the 119th Congress would either stretch that holding period to five years or reclassify carried interest as ordinary income altogether. For a manager earning $10 million in carry, the difference between capital gains treatment and ordinary income treatment can exceed $1.5 million in federal tax alone.
Why Carried Interest Gets Capital Gains Treatment
Private investment funds are organized as partnerships. The general partner typically collects an annual management fee plus a 20% share of the fund’s profits, and that profit share is the carried interest. Because the fund is a partnership, the manager’s carry flows through as a distributive share of the partnership’s gains rather than as salary or bonus. If those gains come from selling assets the fund held long enough, they keep their character as long-term capital gains on the manager’s personal return.
The manager never contributed the capital that produced the profit, yet the income is taxed as if they had. That mismatch is what every reform proposal targets.
The Three-Year Holding Period Under Section 1061
Before 2018, fund managers only needed a one-year holding period to qualify for long-term capital gains treatment on their carry, the same rule that applies to any investor. The Tax Cuts and Jobs Act added Section 1061 to the Internal Revenue Code, which targets “applicable partnership interests.” Any capital gain allocated to a fund manager through such an interest is recharacterized as short-term unless the underlying asset was held more than three years.1Office of the Law Revision Counsel. 26 U.S. Code 1061 – Partnership Interests Held in Connection With Performance of Services
Short-term capital gains are taxed at ordinary income rates, so failing the three-year test erases the rate advantage. Section 1061 is permanent. Unlike the individual rate cuts in the same 2017 law, the three-year holding period has no sunset date and applies regardless of what happens with other tax provisions.
Section 1061 reaches anyone holding an applicable partnership interest received for substantial services in an “applicable trade or business” that raises or returns capital and invests in “specified assets”: securities, commodities, real estate held for rental or investment, cash equivalents, and options or derivatives on any of those categories.1Office of the Law Revision Counsel. 26 U.S. Code 1061 – Partnership Interests Held in Connection With Performance of Services In practice, that sweeps in private equity firms, hedge funds, venture capital firms, and real estate investment partnerships.
The 3.8% Net Investment Income Tax
On top of the capital gains rate, carried interest is usually subject to the 3.8% net investment income tax under Section 1411. The surtax applies to the lesser of a taxpayer’s net investment income or the amount by which modified adjusted gross income exceeds $200,000 for single filers or $250,000 for married couples filing jointly.2Office of the Law Revision Counsel. 26 U.S. Code 1411 – Imposition of Tax Those thresholds have never been adjusted for inflation. Virtually every fund manager earning carry exceeds them.
So the practical numbers look like this. Carry that clears the three-year holding period faces an effective federal rate of 23.8% (20% plus 3.8%). Carry that fails the holding period and gets recharacterized as short-term faces the top ordinary rate plus the 3.8% surtax, reaching 40.8% at a 37% top bracket, or higher if the top bracket returns to 39.6% in 2026.
Exceptions That Shape Who Actually Pays
Not all income flowing through a fund partnership falls under Section 1061. Three exceptions do most of the work.
Capital Invested by the Manager
When a fund manager puts their own money into the fund alongside limited partners, the returns on that personal capital are excluded from Section 1061. To qualify, the allocations on the manager’s invested capital must be calculated in a similar manner as allocations to unrelated non-service partners who hold at least 5% of the fund’s total capital contributions, and the fund’s books must clearly separate capital interest allocations from carry.3eCFR. 26 CFR 1.1061-3 – Exceptions to the Definition of an API Sloppy recordkeeping lets the IRS treat the manager’s entire interest as an applicable partnership interest.
Section 1231 Property and Real Estate
Gains from property used in a trade or business, known as Section 1231 gains, are excluded from Section 1061 entirely. Treasury’s final regulations concluded that Section 1231 gains derive their long-term character from Section 1231 itself, not from the general capital gains rules, so the three-year recharacterization doesn’t reach them.4Federal Register. Internal Revenue Service – Guidance Under Section 1061
Rental property acquired, managed, and held for collecting rents generally qualifies as Section 1231 property. That means carry on gains from selling rental properties can get long-term capital gains treatment under a one-year holding period rather than the three-year rule. Carried interest in real estate partnerships is meaningfully more tax-efficient than carry in securities-focused funds for that reason.
Corporate Partners
Section 1061 does not apply to any partnership interest held directly or indirectly by a corporation.1Office of the Law Revision Counsel. 26 U.S. Code 1061 – Partnership Interests Held in Connection With Performance of Services A management company structured as a C corporation sits outside the three-year requirement, but corporate income is taxed at 21% and distributions to owners face a second layer of tax as dividends. For most managers the double-tax cost outweighs the benefit, though some structures do use the exception.
Reform Proposals on the Table
Carried interest taxation has survived multiple reform attempts over the past fifteen years. The current push comes from two directions: bills that would eliminate the preference entirely and proposals that would extend the required holding period.
The Carried Interest Fairness Act
Introduced in the 119th Congress as S.445, the Carried Interest Fairness Act would reclassify all carried interest income as ordinary income taxed at the same rates as wages.5Congress.gov. S.445 – 119th Congress – Carried Interest Fairness Act of 2025 It would also subject that income to self-employment taxes. For a top-bracket manager, that means paying the 37% or 39.6% ordinary rate plus 2.9% Medicare, with an additional 0.9% Medicare surtax above $200,000 for single filers or $250,000 for joint filers, regardless of how long the fund held its assets.
The bill keeps an exception for returns on the manager’s own invested capital, consistent with the current capital interest carve-out. It also reaches beyond traditional partnerships to cover equity interests in S corporations and special purpose acquisition companies, closing structures some managers have used to sidestep partnership-based rules. If the full bill became law, the effective federal rate on carry could exceed 40% for top earners, compared with 23.8% today for gains on assets held more than three years.
A Five-Year Holding Period
A softer approach would keep capital gains treatment but stretch the required holding period from three years to five. Congress considered this in 2021 budget reconciliation legislation, though it did not pass.6Tax Law Center at NYU Law. Carried Interest and Beyond – A Short List of Legislative Options Focused on Private Equity Five years would hit buyout funds hardest, since many private equity deals run three to five years. Managers whose funds sell portfolio companies at the four-year mark would lose the capital gains rate on that carry entirely.
What the 2025 Reconciliation Package Did Not Do
The major tax reconciliation package moving through the 119th Congress, the One Big Beautiful Bill Act, does not include changes to carried interest taxation. Section 1061’s three-year holding period and the general framework for taxing carry remain intact. The preference has been a perennial target in budget negotiations and has consistently survived final votes, often on the argument from the private equity and real estate industries that long-term capital deployment creates economic value distinct from ordinary service income.
How TCJA Expiration Interacts With the Debate
The TCJA individual rate cuts were scheduled to expire at the end of 2025, which would push the top ordinary bracket from 37% back to 39.6%.7Congress.gov. Expiring Provisions in the Tax Cuts and Jobs Act (TCJA, P.L. 115-97) Whether Congress extends those rates for 2026 has direct implications for carried interest, though perhaps not in the way most people assume.
The top long-term capital gains rate of 20% is not a TCJA provision. It has been permanent since 2013 and does not change regardless of what happens with ordinary rates. If the top ordinary rate reverts to 39.6%, the gap between capital gains treatment and ordinary income treatment actually widens, making the carried interest preference more valuable to managers and more costly to the Treasury. Section 1061’s three-year holding period is also permanent. The expiration of TCJA rate cuts does not fix the carried interest question. If anything, it sharpens it.