What Is the Carried Interest Loophole? How It Works and Examples

A fund or a single-deal vehicle is usually set up as a partnership. The investors put in the capital. The manager receives carried interest, a right to a share of the profits that is paid only if the investments make money. A partnership passes the type of its income through to its partners. So when the fund sells shares at a gain, the manager’s slice of that gain arrives as capital gain, just as the investors’ slices do.

That is the carried interest loophole explained in one step, and it is why the taxation of carried interest is contested. The manager puts in little or no capital. The carry rewards work: finding deals, negotiating, managing and selling. Work is normally taxed as ordinary income, at the same rates as salary. Carry is structured as a partnership profit share, so it is taxed as capital gain. The management fee is different. It is a fee for services and is taxed as ordinary income whatever the fund holds.

Since 2018, the loophole has come with a condition. Section 1061 of the Internal Revenue Code was added by the Tax Cuts and Jobs Act of 2017. It applies to an applicable partnership interest. That is an interest received for substantial services in an investment business. The business raises or returns capital and invests in securities, commodities, real estate held for investment, cash or derivatives. For gain on that interest, long-term status needs a holding period of more than three years instead of more than one. Gain that clears one year but not three is reclassified as short-term capital gain and taxed at ordinary rates.

• Whose holding period countsGenerally the partnership’s holding period in the asset it sells. What counts is how long the fund held the company. The manager’s own years in the fund do not count.
• Capital the manager investsGain on the manager’s own invested capital is outside the rule, as it would be for any investor.
• Transfers to related peoplePassing the interest to family members or colleagues does not escape the rule. Short-term gain is recognized, meaning counted for tax, on the transfer.
• ReportingSince the final regulations of January 2021, the partnership attaches a worksheet to the holder’s K-1, the yearly tax form a partnership gives each partner. The worksheet splits one-year and three-year gains.

Your own position as an investor in the fund or vehicle is unaffected. Your share of the same gain is long-term after one year, under the ordinary rules. Section 1061 applies only to the interest held for services.

Below the top brackets, the rates are lower on both sides. For example, the 15% capital-gains rate covers single taxable income from $49,450 to $545,500. A manager’s carry, though, tends to land in the top bracket in the year a large exit closes. State income tax comes on top in most states and taxes carry the same way as other gains.

A vehicle raises $100 million, buys shares in one private company and sells them for $150 million. The $50 million gain is split under the vehicle’s documents: 20% carry to the manager and 80% to the investors. The table shows the same exit twice: once after three and a half years and once after two and a half.

Exiting a year early raises the manager’s federal tax from $2,380,000 to $4,080,000, or 71% more. In pre-IPO deals, that gap matters more than it looks. A vehicle may buy secondary shares, meaning shares bought from existing holders, a year or two before a listing. It can then easily exit inside three years, and its manager’s carry is short-term. That gives the manager a reason to hold a little longer. An investor may not have the same reason. On Axevil, each deal runs through its own Delaware SPV managed by Axevil Capital, LLC. The carry rate and fees are set per deal and written in that SPV’s documents. See SPV fees for where to find them.

Proposals to tax carry as ordinary income have been introduced in Congress for years. The current ones are the Carried Interest Fairness Act of 2025 in the Senate (S. 445, sponsored by Senator Tammy Baldwin) and its House companion, H.R. 1091. Both were introduced on February 6, 2025, and referred to committee. They would treat carry gains as ordinary income and apply self-employment tax to them. Neither has become law.

The One Big Beautiful Bill Act, signed on July 4, 2025, was widely expected to change how carry is taxed. It did not. Section 1061 and the capital-gains treatment of carry were left as they were. As of October 2026, the three-year rule enacted in 2017 is the rule in force.

• “Investors get the loophole too”Investors in a fund already get long-term treatment after one year. The loophole concerns only the manager’s profit share.
• “Section 1061 closed it”It narrowed it. Carry on assets held more than three years is still long-term capital gain.
• Counting the manager’s years in the fundThe test generally looks at how long the partnership held the asset it sold. When the manager joined does not matter.
• Treating the fee and the carry alikeThe management fee is ordinary income whatever happens. Only the carry can be capital gain.
• Quoting a proposal as lawBills to end the treatment are introduced regularly. Until one is enacted, the 2017 rule applies.

Carried interest

The manager’s share of a fund’s or vehicle’s profits, paid only after investors’ capital, and usually a hurdle, are returned.

Applicable partnership interest

A partnership interest received for substantial services in an investment business. Gain on it needs more than three years to be long-term.

Long-term capital gain

Gain on an asset held more than one year, or more than three for carry. Taxed at 0%, 15% or 20% in 2026.

Short-term capital gain

Gain on an asset held for a shorter period. Taxed as ordinary income, up to 37% in 2026.

Ordinary income

Income such as wages and fees, taxed at the regular rates, up to 37% in 2026.

Net investment income tax

A 3.8% federal tax on investment income for individuals above $200,000 of modified AGI ($250,000 joint).

Management fee

The annual fee a manager charges on committed or invested capital. A fee for services, so always ordinary income.

Schedule K-1

The yearly tax form a partnership gives each partner, showing that partner’s share of income and gains.

Every rate, threshold and date was checked against the primary source on October 1, 2026, and applies to tax year 2026. Legislative proposals are reported as introduced. Their later progress was not tracked here. The worked example is illustrative arithmetic.