Carried interest is taxed as long-term capital gain at a top federal rate of 20% only when the underlying asset was held for more than three years; otherwise Section 1061 recharacterizes the gain as short-term and it is taxed at ordinary income rates up to 37%. That is the whole contest between capital gains and ordinary income treatment for fund managers, and every planning question in this area comes back to whether the three-year holding period is met.
What the Rate Difference Actually Costs
When carry qualifies for long-term capital gains treatment, the top federal rate is 20%. For 2026, that rate applies to single filers with taxable income above $545,500 and married couples filing jointly above $613,700.
High-income managers also owe the 3.8% Net Investment Income Tax. The NIIT applies to the lesser of net investment income or the amount by which modified adjusted gross income exceeds $200,000 for single filers and $250,000 for joint filers.1Internal Revenue Service. Net Investment Income Tax Stacked together, the top federal rate on qualifying carried interest is 23.8%.
Ordinary income is a different picture. The top marginal rate for 2026 is 37%, reaching single filers above $640,600 and married couples filing jointly above $768,700.2Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026 On a $10 million carry allocation, the gap between 23.8% and 37% is roughly $1.32 million in federal tax. That is the price of missing the three-year mark.
The Three-Year Rule Under Section 1061
Section 1061 was added by the Tax Cuts and Jobs Act in 2017 and is a permanent part of the Internal Revenue Code. It applies to what the statute calls an “applicable partnership interest,” or API: any partnership interest received in connection with performing substantial services in an investment business. Long-term capital gain allocated to an API holder is recharacterized as short-term capital gain unless the underlying asset was held for more than three years.3Office of the Law Revision Counsel. 26 U.S. Code 1061 – Partnership Interests Held in Connection With Performance of Services
Ordinary capital gains rules give long-term treatment after one year. Section 1061 triples that. A private equity fund that buys a portfolio company and exits at a profit two and a half years later produces gain that would be long-term under the default rule but is taxed at ordinary income rates on the GP’s carry share. Only gain on assets held past three years keeps the 20% rate.
The statute also overrides Section 83 and any Section 83(b) election, so an early election on receipt of the partnership interest does not sidestep the three-year test.3Office of the Law Revision Counsel. 26 U.S. Code 1061 – Partnership Interests Held in Connection With Performance of Services
How Recharacterization Is Calculated
The mechanics compare two versions of the API holder’s net long-term capital gain: one measured with the standard one-year holding period and one measured with the three-year period. The difference is the recharacterization amount, and that amount becomes short-term capital gain. When a fund holds a mix of assets, only the gain attributable to assets held between one and three years gets reclassified. Gain on assets held beyond three years keeps its favorable treatment.4Internal Revenue Service. Section 1061 Reporting Guidance FAQs
Which Partnerships and Gains Are Covered
Section 1061 targets partnerships that raise or return capital and invest in “specified assets”: securities, commodities, real estate held for rental or investment, cash and cash equivalents, and options or derivatives on any of those. Interests in other partnerships count to the extent those partnerships hold specified assets.3Office of the Law Revision Counsel. 26 U.S. Code 1061 – Partnership Interests Held in Connection With Performance of Services The definition covers most private equity, venture capital, hedge fund, and real estate fund managers.
An operating business partnership, where no one is raising capital to invest in financial assets, falls outside the statute. The line matters most for managers who run an operating business through the same entity that holds investment assets.
Certain categories of gain are excluded from recharacterization even when they flow through an API. Section 1231 gains and losses (business property held over a year), gains and losses on Section 1256 contracts such as regulated futures and certain options, and qualified dividends keep their normal character regardless of holding period.
Structures That Avoid the Three-Year Rule
Partnership Interests Held by a Corporation
A partnership interest held directly or indirectly by a corporation is not an API. A fund manager who holds the GP interest through a C corporation is outside Section 1061, and the ordinary one-year holding period applies.5eCFR. 26 CFR 1.1061-3 – Exceptions to the Definition of an API The corporation pays corporate tax on the income, and the manager pays tax again on extracting the funds, so the structure is not a free win.
The GP’s Own Capital Co-Investment
When a GP invests personal capital in the fund alongside the LPs, returns on that capital are not subject to the three-year rule, provided the GP’s capital interest gives a right to share in partnership capital proportional to what was contributed.3Office of the Law Revision Counsel. 26 U.S. Code 1061 – Partnership Interests Held in Connection With Performance of Services Allocations to the GP’s capital interest have to be made in the same manner as allocations to unrelated LPs holding at least 5% of total commitments, and the partnership must keep contemporaneous books that clearly separate capital interest allocations from carry allocations. If recordkeeping falls short, the IRS can treat the entire interest, including the capital piece, as an API.
How Carried Interest Gets Reported
The partnership handles most of the compliance. For each API holder, the partnership attaches Worksheet A to the Schedule K-1, showing both the one-year and three-year distributive share amounts. On Form 1065, the figures go in box 20 using code AH.4Internal Revenue Service. Section 1061 Reporting Guidance FAQs
The API holder then completes Worksheet B, which pulls the one-year and three-year figures from every API the holder owns, computes the excess, and reports that excess as short-term capital gain on Form 1040. Worksheet B is attached to the return. Both worksheets have been required under the final regulations for returns filed after December 31, 2021.4Internal Revenue Service. Section 1061 Reporting Guidance FAQs
Managers with interests in multiple partnerships or tiered fund structures need to aggregate their Section 1061 amounts across all APIs before finishing Worksheet B. Missing that aggregation is one of the common compliance errors when a manager receives several K-1s that each carry their own Worksheet A.
Where the Law Stands Now
Section 1061 has no sunset date. The 2025 reconciliation legislation, the One Big Beautiful Bill, did not change carried interest taxation, and the 37% top ordinary income rate was extended for 2026.2Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
Proposals to go further keep appearing. The Carried Interest Fairness Act of 2025, introduced in the Senate as S.445, would treat all capital gains allocated to investment management partnership interests as ordinary income, eliminating the preferential rate entirely rather than just extending the holding period.6Congress.gov. S.445 – Carried Interest Fairness Act of 2025 The bill has not been enacted. Plan on the current three-year framework staying in place, but recognize that future tax legislation could revisit carry with little warning.