Section 1061 Carried Interest: The Three-Year Holding Playbook for Fund Managers

A private equity manager holds a 20 percent carried interest. The fund sells a portfolio company after two years and allocates the manager a $10,000,000 gain. Under the ordinary one-year rule that gain would be taxed at 20 percent plus the 3.8 percent net investment income tax: $2,380,000. Under Section 1061 the same gain is taxed as short-term capital gain at 37 percent plus 3.8 percent: $4,080,000. The difference is $1,700,000, and the only thing that changed is the calendar.

Section 1061 is for fund managers, sponsors and developers who hold a profits interest for services — not for limited partners who put in cash, and not for corporations.

The decision in one table

What Section 1061 does

Congress added Section 1061 in the Tax Cuts and Jobs Act of 2017: the statute takes net long-term capital gain from applicable partnership interests, substitutes three years for one year in the holding-period test, and treats the excess as short-term capital gain:

The excess is taxed at ordinary rates even though nothing about the asset changed. The rule reaches only gain that is long-term capital gain under Section 1222(3) and (4) — that limit is the doorway to every planning point here.

An applicable partnership interest, or API, is any partnership interest transferred to or held by a taxpayer in connection with substantial services in an applicable trade or business — raising or returning capital and investing in specified assets or developing them, conducted on a regular, continuous and substantial basis. Specified assets are securities, commodities, real estate held for rental or investment, cash and equivalents, and derivatives on any of those. Section 1061(b) adds a narrow carve-out for gain on an asset not held for portfolio investment on behalf of third-party investors.

Who it catches, and who escapes

The section catches the classic carry: a profits interest with no capital behind it, granted for services in a fund that raises capital and invests in specified assets, held directly or through tiers of pass-through entities. It also catches an API held by an S corporation, which the corporation exception does not treat as a corporation.

It does not catch everyone who touches a fund. Four exits matter:

• A corporation. An interest directly or indirectly held by a corporation is not an API, under Section 1061(c)(4)(A).
• A capital interest. Under Section 1061(c)(4)(B), an API does not include a capital interest that gives a right to share in partnership capital commensurate with the amount contributed, or with the value taxed under Section 83 on receipt or vesting.
• A bona fide purchaser. An API bought at fair market value by someone who provides no services and is unrelated to any service provider is not an API.
• An employee of a non-ATB entity. An interest held by a person employed by an entity conducting a non-ATB trade or business, who provides services only to that entity, is not an API.

See also our Section 199A QBI deduction playbook and our Form 1065 partnership return playbook.

Example 1: the $10,000,000 two-year gain

Example 1 is the whole rule in one calculation. A single-filer fund manager is allocated a $10,000,000 gain from a portfolio company the fund held for two years. Total taxable income is far above the 2026 20 percent threshold of $545,500, so the top rates apply, and the gain is net investment income above the $200,000 threshold.

The recharacterization costs 17 percentage points on the same dollars. The 3.8 percent net investment income tax applies in both cases, so the rate that moves is 20 percent versus 37 percent.

Example 2: the $2,000,000 gain and the one-year wait

Example 2 is the same rule at a smaller scale. A manager is allocated a $2,000,000 gain from an asset held two years: $816,000 recharacterized, $476,000 held past three years — a $340,000 saving from one more year of holding.

A buyer who pays the same price in month 37 as in month 24 is worth $340,000 more to this manager. That is the commercial point of Section 1061: the exit calendar is a tax term, and it belongs in the sale agreement. A CPA should confirm the computation before signing — the three-year test runs from the fund's acquisition of the asset, not the carry grant.

Example 3: the capital-interest slice saves $170,000

Example 3 shows the capital-interest exception doing real work: a manager's total allocation from a fund sale is $5,000,000 — $1,000,000 attributable to the manager's own contributed capital and $4,000,000 to the carry. The fund held the asset two years.

If the whole $5,000,000 had been carry, the tax would be $2,040,000. The documented capital interest saves $170,000. T.D. 9945 sets the test: allocations to the capital interest must be calculated in a similar manner to allocations for unrelated non-service partners with significant aggregate capital of at least 5 percent, with reasonably consistent distribution rights, and the interest must be clearly identified in the agreement and books, contemporaneously. Capital financed with fully recourse debt can qualify; reinvested realized gains count as a contribution, while an incentive allocation on unrealized appreciation does not.

What Section 1061 does not touch

The final regulations confirm Section 1061 applies only to gains treated as long-term capital gain under Sections 1222(3) and (4) — not to qualified dividend income, Section 1231 gains, Section 1256 gains, or amounts treated as ordinary income under Sections 751 or 1245. That exclusion is the largest planning opening in the section.

A developer's promote is the cleanest illustration: the promote generally qualifies as an API, but gain on real property used in a trade or business is Section 1231 gain, so Section 1061 does not recharacterize it. The same logic helps a fund exiting a portfolio company in an asset sale — much of the gain can be Section 1231 gain on goodwill and depreciable assets — while a sale of the equity interests does not qualify. Price the exit structure before the letter of intent.

Selling the carried interest itself

When a manager sells the API itself to a third party, the manager's own holding period in the API governs — not the partnership's holding period in the underlying assets. A manager who has held the carry for more than three years generally keeps long-term treatment even if the fund's assets are younger.

The final regulations narrowed the look-through rule: the proposed 80 percent asset test is gone. T.D. 9945 applies it only where the API would be three years or less if the period before an unrelated non-service partner became legally obligated to contribute substantial money or property were disregarded — the anti-aging rule for a fund formed long before its investors arrive — or where a transaction has a principal purpose of avoiding recharacterization.

Our Section 1031 like-kind exchange playbook covers the voluntary deferral Section 1061 is not: Section 1031 defers gain on a chosen exchange; Section 1061 recharacterizes gain on a holding-period test.

Transferring the interest to a related person

Section 1061(d) is the trap most summaries get wrong. A taxpayer who transfers an API to a related person — a family member within Section 318(a)(1), or a person who performed services in the same applicable trade or business in the current or preceding three calendar years — includes in gross income, as short-term capital gain, the long-term gain on assets held not more than three years.

T.D. 9945 narrowed that trap: Section 1061(d) does not accelerate gain on every transfer to a related person. It recharacterizes only long-term gain the taxpayer actually recognizes on a taxable sale or exchange of an API to a related person. A gift to a family member, otherwise a non-recognition transfer, does not trigger Section 1061(d).

Example 4 is the taxable-sale case: a manager sells an API to a related person, and the long-term gain on assets the partnership held three years or less is $1,500,000 — recharacterized as short-term capital gain:

The same transfer as a gift would recognize no gain at the time of transfer. The difference between a sale and a gift to the same family member is $612,000 of tax on the same interest. A CPA should review any related-person transfer before it is documented: the form of the transfer decides the tax.

Reporting: what the fund must track

The final regulations impose reporting duties: a partnership that has issued APIs must track more-than-three-year gains, three-year-or-less gains, and capital-interest gains and losses, and report them to the API holders and to the IRS. Each pass-through entity in a tiered structure is treated as holding an API, and the recharacterization amount is determined at the owner-taxpayer level. Failure to report can draw penalties under Regulations Sections 1.1061-3 and 1.1061-4. A fund administrator who has not set up the three buckets before the first exit is already behind.

The 2026 rate table

The 2026 thresholds come from Revenue Procedure 2025-32, Section 4.03, and apply to total taxable income, not the gain alone — salary and other ordinary income fill the bands first.

The 3.8 percent net investment income tax sits on top of these rates above $200,000 of modified adjusted gross income for a single filer and $250,000 for joint filers, under Section 1411(b) — unindexed for inflation. Run your own facts through our tax estimator before relying on the top-rate math above.

Effective date and reliance

T.D. 9945 was issued January 7, 2021, and generally applies to tax years beginning on or after Federal Register publication — January 1, 2022 for a calendar-year taxpayer. Taxpayers may rely on it for any taxable year beginning after December 31, 2017, provided they apply it consistently in its entirety to that year and all subsequent years.

Operator boundaries

Section 1061 is for a narrow operator: a fund manager, sponsor or developer who receives a profits interest for services in a fund that raises capital and invests in specified assets. It is not for a limited partner who contributes cash and performs no services — that partner holds a capital interest, not an API — nor for a C corporation manager, or an employee of an operating company that is not an applicable trade or business.

A manager still structuring a fund should settle three things before the first close: whether the carry is documented as an API with a separate, clearly identified capital interest; whether the agreement and books support the exception; and whether the exit calendar is a negotiated term.

Execution checklist

• [x] Step 1: Confirm API status: the interest was transferred for substantial services, no exception applying.
• [x] Step 2: Separate the capital interest: contribute capital, document the right, and identify it in the agreement and books.
• [x] Step 3: Record acquisition dates: the test runs from the fund's acquisition of each asset.
• [x] Step 4: Price the exit calendar: month 37, not month 24, is worth 17 points on the carry.
• [x] Step 5: Check the exclusion: Section 1231 gain, Section 1256 gain and qualified dividends sit outside it.
• [x] Step 6: Review related-person transfers: a taxable sale recharacterizes; a gift does not accelerate.
• [x] Step 7: Set up reporting: track the three gain buckets (Regulations Sections 1.1061-3 and 1.1061-4).