Carried interest is a fund manager’s share of a fund’s investment profits — conventionally 20% — which is taxed as long-term capital gain rather than as ordinary income.
In plain terms
An investment fund is a partnership. Outside investors put up the money; the firm running the fund invests it. The firm charges an annual management fee, taxed like a salary, and takes a slice of the profits, which is not. That profit slice is the carried interest, or “the carry.” Because it is structured as an ownership stake in a partnership rather than as a fee for services, the income keeps the character of the underlying gain on its way to the manager — and a gain on an asset held for years is a long-term capital gain.
How it works
The general partner is granted a profits interest when the fund is formed. No tax is due at that point, because the interest has no value yet. Years later the fund sells its companies, and the proceeds run through a distribution waterfall: capital back to the investors first, then the hurdle, then a catch-up, then the residual split — typically 80/20. That 20% is the carry, and each dollar of it inherits the tax character of the gain that produced it.
The 2017 Tax Cuts and Jobs Act added Section 1061, which requires the fund to have held the asset for more than three years — rather than the usual one — for the manager’s share to qualify for long-term rates. It changed the timing. It left the character alone.
The numbers
- Top federal rate on long-term capital gain (2026): 23.8% — the 20% headline rate plus the 3.8% net investment income tax.
- Top federal rate on ordinary income: 40.8%.
- The spread: 17 points. On a $10 million carry allocation, roughly $1.7 million of federal tax.
- Conventional split: 20% of profits to the general partner, often above an 8% annual hurdle.
- Holding period required: more than three years, under Section 1061.
- Estimated size of the annual US carry pool: roughly $35 billion in 2011 rising to roughly $89 billion in 2020, per research by Michael Love published in the Journal of Public Economics.
- Ten-year revenue from taxing it as ordinary income: between about $6 billion and about $100 billion, depending entirely on the design of the bill.
What people get wrong
That it is a hedge fund break. Nearly every press release on the subject says “hedge fund managers,” but hedge funds benefit least — many strategies trade in and out of positions inside a year, so the gains are short-term and taxed at ordinary rates regardless. Carried interest is worth most to buyout, growth, venture, and real estate funds, which hold assets for years by design. The second thing people get wrong is that it is a drafting error. It follows straightforwardly from a century of partnership tax law, which is precisely why it has proved so hard to remove.
Related
Read more: Carried Interest: The Most Defended Loophole in American Tax · Hedge Funds and Private Equity · Venture Capital: The Culture of Tech Money
See also: Limited partner and general partner · Distribution waterfall · Hurdle rate