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Carried Interest Post-TCJA: Impact on Hedge Funds, Private Equity, and Real Estate

Academics, tax practitioners, and members of both political parties in the US have criticized the so-called carried-interest loophole for many years.1 Although a recent proposal to close the loophole estimated the US Treasury would only collect an additional $17 billion in revenue over ten years,2 the loophole continues to receive criticism due to its political unpopularity and perceived unfairness.3 Critics of the §1061 carried-interest provision argue that allowing investment fund managers to pay a capital gains rate on income received for services provides an unfair tax break to the wealthy and increases income inequality.4 During his campaign, President Trump promised to close the carried-interest loophole, calling out hedge fund managers as “paper pushers” who were “getting away with murder.”5 Yet when President Trump signed the Tax Cuts and Jobs Act (TCJA) into law on December 22, 2017, the carried-interest provision remained largely intact and only included a slight modification: investment fund managers must now hold “applicable partnership interests” for three years to qualify for the preferential capital gains rate.6 In response, several states proposed legislation to close the loophole at the state level.7 To-date, no state has passed and enacted such legislation,8 in part due to worries that investment funds will flee any state that taxes carried-interest if other states do not follow suit.9 As a result, the TCJA’s changes to the carried-interest provision will likely have some impact on hedge funds and a minimal impact on real estate investment entities and private equity funds.10

The TCJA amended §1061 so that the long-term capital gains rate would only apply to applicable partnership interests held for three or more years. An applicable partnership interest is defined as “any interest in a partnership which, directly or indirectly, is transferred to (or is held by) the taxpayer in connection with the performance of substantial services by the taxpayer, or any other related person, in any applicable trade or business.”11 An applicable trade or business is an activity that is regular, continuous, and substantial and consists of raising or returning capital, and either investing in or disposing of specified assets or developing specified assets.12

An applicable partnership interest for purposes of §1061 has two main exceptions. First, a fund manager’s own “capital interest” based on his/her capital contributions is excluded from the definition of applicable partnership interest.13 As a result, a fund manager receiving a pro-rata share of a fund’s profits based on his/her capital contribution is not subject to the three-year holding period and can qualify for the long-term capital gains rate on this portion of their interest as long as the capital interest is held for more than one year. However, a fund manager’s “profit interest” is likely included in the definition of applicable partnership interest and thus subject to the three-year holding period. Revenue Procedure 93-27, although never finalized, defines a profit interest as a “partnership interest other than a capital interest.”14 In practice, a profit interest is a partnership interest that “would not entitle the holder to a share of the proceeds if partnership assets were sold for their fair market value and the net sale proceeds were distributed to the partners in liquidation.”15 This would include the fund manager’s interest in 20 percent of the future profits of the fund, as is typical in a standard 2 and 20 arrangement.

Second, §1061 also excludes corporations from the definition of applicable partnership interest.16 Although this presumably applies to C-corporations, some practitioners initially argued that a profits interest held through an S-corporation might also not be subject to the three-year holding period. In early 2018, many hedge fund managers set up LLCs to store their carried interest because electing to have the LLC treated as an S-corporation could potentially allow the fund managers to avoid the three-year holding period.17 However, The IRS released a bulletin in March 2018 explaining that future regulations would clarify that the term “corporation” in §1061(c)(4)(A) does not include S-corporations, meaning S-corporations holding an applicable partnership interest are still subject to the three-year holding period.18 Some tax practitioners have noted that the IRS may not have the authority to enforce this interpretation without Congress amending the law, although the legislative history of the statute and the broad deference given to agency interpretations of statutes may suggest otherwise.19

The TCJA also creates some uncertainty regarding the holding period required for both the applicable partnership interest and the capital assets held by the partnership. Under the new law, the applicable partnership interest and the capital assets sold by the partnership must both potentially be held for more than three years in order to qualify for long-term capital gain treatment. For example, if a taxpayer sells an applicable partnership interest after holding the interest for three years or less, gain on certain capital assets held by the partnership might be treated as ordinary income under §751 and any other gain would be treated as short-term capital gain under §1061. Likewise, if a taxpayer sells an applicable partnership interest after holding the interest for more than three years, gain on certain capital assets held by the partnership might be treated as ordinary income under §751 and any other gain on capital assets would be treated as long-term capital gain under §1061. This long-term capital gains treatment would likely apply to capital assets held in the applicable partnership interest for three years or less. However, if the partnership sold a capital asset with a holding period of three years or less, the gain passing through to a partner holding an applicable partnership interest would likely be taxed as short-term capital gain even if the partner held her applicable partnership interest for more than three years. In contrast, if a partnership sold a capital asset with a holding period over three years, the gain passing through to a partner holding an applicable partnership interest would likely be taxed as long-term capital gain even if the partner held his/her applicable interest for three years or less.20

In addition, there is some uncertainty regarding how transfers to related parties are treated. Under the new §1061, if a fund manager transfers their partnership interest to a related party, the fund manager must recognize gain attributable to assets held for less than three years as short-term capital gain. “Related person” is limited to family members as defined in §318 and anyone who performed a service within the three preceding calendar years in any applicable trade or business in which the fund manager also performed a service.21 As some practitioners have noted, it is unclear if this provision is intended to address “routine transactions that would otherwise be non-taxable,” such as transfers to a family estate vehicle.22

With regard to hedge funds, the old §1061 generally only affected hedge fund managers who held assets for more than one-year. For “activist” hedge fund managers holding assets for a year or less, any profit realized on the sale of such assets was considered short-term capital gain and thus taxed at the top ordinary income rate of 43.4 percent (includes the 3.8 percent net investment income tax).23 As result, expanding the holding period to three years will likely have a minimal effect on hedge fund managers’ future activities as most hedge fund managers did not get capital gains treatment on their carried interest prior to the passage of the TCJA because they did not hold assets for more than one year.

However, the scope of what constitutes a capital interest excluded from the three-year holding period under the new §1061 may be an area of concern for some hedge fund managers. Many fund managers hold carried interest profits in a general partner capital account in three forms: realized gains that have been reinvested in the fund, unrealized gains held in the fund, and an interest in the future profits of the fund. Prior to the passage of the TCJA, fund managers would often reinvest realized and taxed gains directly back into the fund where the gains originated. Although §1061(c)(4)(B)(i) states that capital contributions by the fund manager are not subject to the three-year holding period, hedge fund managers are uncertain whether profits reinvested in the fund would be considered a capital contribution, particularly if the reinvested funds are grouped together with unrealized gains held in the fund manager’s capital account. To be safe, many fund managers have removed their realized gains from their capital accounts in active funds into separate entities that they own. By doing so, they can then re-contribute these realized gains to the actively managed fund and qualify this contribution as a capital contribution.24

With regard to private equity funds and real estate funds, the new §1061 will likely have little effect on fund managers’ activities due to the average holding period and nature of the assets held by these funds. For example, only 27 percent of private equity portfolio investments were held for three years or less in 201725 and private equity funds typically hold assets for at least four to five years.26 As a result, the three-year holding period requirement would not affect these types of funds. Real estate funds also tend to hold assets for longer than three years.

Moreover, real estate funds generally hold §1231 property rather than “ordinary” capital assets, and it is unclear whether §1061 applies to gain on the sale of §1231 property. §1231 property is real or depreciable property used in a taxpayer’s trade or business and held for more than one year, and gains on §1231 are taxed at the long-term capital gains rate of 20 percent.27 For a real estate fund, §1231 property includes real property such as apartments held for rent, and §1231 gain would be characterized as long-term capital gain if the fund held the apartments for more than one year. The new §1061 amends the capital gain provisions in §1222 to require a three-year holding period for carried interest, but the holding period stipulated in §1222 does not apply to §1231 property. However, real estate is included in §1061’s definition of specified assets included in the definition of applicable trade or business and thus subject to the three-year holding period.28 If Congress or Treasury does not rewrite/interpret §1061 to apply a three-year holding period to disposition of §1231 property, disposition of such property will likely be exempt from the three-year holding period. This would allow a partner with an applicable interest in a real estate fund to receive long-term capital gains treatment on any gain in excess of the adjusted basis and depreciation taken on §1231 property held for more than a year, which would completely nullify the TCJA’s effect on such a transaction (for purposes of §1061).

That said, §1061 does have the potential to create conflicts between fund managers and investors. Although private equity fund hold-times increased in 2017 and hold-times are generally longer than three years,29 some investments can reach their financial targets in less than three years due to various factors, including “waterfall” payments kicking in or lucrative buyout offers. In these scenarios, investors may want the fund to sell the assets. If the assets were held for more than one year but not more than three years, the investors would realize long-term capital gain and the fund manager would realize short-term capital gain under §1061. As a result, §1061 may incentivize fund managers to hold on to assets longer than their investors want.30 As a result, fund managers should pay attention to waiver of conflict clauses in fund documents and might even consider adding specific language addressing the conflict of interest created by the TCJA’s changes to §1061. Alternatively, fund managers could consider alternative structures that align their incentives with those of fund investors. For example, one tax practitioner suggested managers could utilize structures such as “leveraged recapitalizations, [which] may produce qualified dividend income taxed at long-term capital gains rates.”31

Another area of ambiguity is §1061(b), which says the three-year holding period is not applicable to “income or gain attributable to any asset not held for portfolio investment on behalf of third party investors.”32 Although it is not entirely clear what this exception is aimed at, some practitioners have noted that this could be applied to a “hedge or PE firm’s ownership of investment or business assets in LLCs that don’t include outside investors.”33 These investments could include assets like office buildings owned by a private equity firm that issues “incentive units” to its employees in an LLC, which owns the office building. Other practitioners hypothesize that this exception is meant to segregate “enterprise value” or goodwill from carried interest and exempt such value from the three-year holding period of §1061.34 Further clarification from Congress is needed in this area.

Finally, an additional area of uncertainty involves converting a contingent carried-interest to a fixed-percentage interest. In some circumstances, investors and the fund manager may want to convert the fund manager’s carried interest contingent on profits to a fixed-percentage interest in the partnership. In such a situation, it is unclear if the three-year holding would restart on the date of the conversion or on the date the fund manager becomes a fixed partner in the fund, and further clarification from Congress is needed in this area.


  1. James B. Stewart, Call to Congress: End Loophole for Tax on Elite, New York Times (Nov. 14, 2014), https://www.nytimes.com/2014/11/15/business/idea-for-new-congress-end-a-tax-break-for-the-elite.html

  2. Chris Isidore & Jill Disis, Tax break for hedge fund managers mostly survives in GOP bill, CNN (Dec. 21, 2017), https://money.cnn.com/2017/12/21/news/trump-carried-interest-tax-plan/index.html

  3. See Sure, closing the carried interest loophole is the right thing to do. But it’s not enough, The Wash. Post: Editorial Board (Mar. 12, 2017), https://www.washingtonpost.com/opinions/sure-closing-the-carried-interest-loophole-is-the-right-thing-to-do-but-its-not-enough/2017/05/12/62f36a64-31ca-11e7-9dec-764dc781686f_story.html?utm_term=.09c484f75cfa

  4. See Lynnley Browning, Carried Interest, Bloomberg (Feb. 23, 2018), https://www.bloomberg.com/quicktake/carried-interest

  5. Amanda Becker, Wall St. tax breaks once blasted by Trump preserved in Republican bill, Reuters (Nov. 3, 2017), https://www.reuters.com/article/us-usa-tax-carriedinterest/wall-st-tax-break-once-blasted-by-trump-preserved-in-republican-bill-idUSKBN1D22Z3

  6. Notice 2018-18, Guidance Under Section 1061, Partnership Interests Held in Connection with Performance of Services, Internal Revenue Bulletin 2018-12 (Mar. 19, 2018), https://www.irs.gov/irb/2018-12_IRB#NOT-2018-18

  7. Lindsey Fortado & Mark Vandevelde, US states move to close carried interest loophole, The Financial Times (May 21, 2018), https://www.ft.com/content/a3b42e18-5adb-11e8-b8b2-d6ceb45fa9d0

  8. See Jeremy Naylor & Kimberly Ann Condoulis, State Tax Law Updates, Proskauer Tax Talks (July 12, 2018), https://www.proskauertaxtalks.com/2018/07/state-tax-law-updates/?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+TaxTalks+%28Proskauer+Tax+Talks%29

  9. See Christopher Keating, Malloy And GOP Say Hedge Fund Tax Could Drive Wealthy Out, Hartford Courant (Apr. 11, 2017), http://www.courant.com/politics/hc-taxes-on-hedge-funds-20170411-story.html

  10. Note that support for closing the carried interest loophole has recently gained some momentum in the US Senate. See Jessica Smith, Democratic lawmakers move to close ‘horrible loophole’ in tax code, Yahoo Finance (Mar. 13, 2019), https://finance.yahoo.com/news/sen-tammy-baldwin-moves-to-close-horrible-loophole-in-tax-code-190339287.html?guccounter=1&guce_referrer=aHR0cHM6Ly93d3cuZ29vZ2xlLmNvbS8&guce_referrer_sig=AQAAACCoN4r9zuBWvxUY3J8aQphyjZfY87uIvdlTIUDsZVUPjeoyIAnHMQ2QBIut3POQKl9iv9-gjN9e4p2Ciw_W8gpTkSg8eNp4cRM-J8AgnmzrWrF3Giom6lzPfshRjzjsdsvWMhDTCyE86lzyKNfZODlKDKlgF-pm09QYW5CyS7r2The). 

  11. IRC §1061(c)(1). 

  12. IRC §1061(c)(2). 

  13. IRC §1061(c)(4). 

  14. 26 CFR §601.201 (1993), https://fortunedotcom.files.wordpress.com/2012/08/rp9327.pdf

  15. Scott W. Dolson, How the New § 1061 Impacts Carried Interests, Frost Brown Todd Attorneys LLC (Feb. 26, 2018), https://www.frostbrowntodd.com/resources-how-new-irc-1061-impacts-carried-interests.html

  16. IRC §1061(c)(4)(A). 

  17. See Miles Weiss, IRS to Ban Hedge-Fund Tax Dodge on Carried Interest, Bloomberg (Feb. 14, 2018), https://www.bloomberg.com/news/articles/2018-02-14/mnuchin-says-irs-to-ban-hedge-fund-tax-dodge-on-carried-interest

  18. Notice 2018-18, Guidance Under Section 1061, Partnership Interests Held in Connection with Performance of Services, Internal Revenue Bulletin 2018-12 (Mar. 19, 2018), https://www.irs.gov/irb/2018-12_IRB#NOT-2018-19

  19. See Scott Dolson et al, Planning Ideas for Avoiding IRC § 1061’s Three-Year Holding Period Requirement, Frost Brown Todd Attorneys LLC (Apr. 24, 2018), https://www.frostbrowntodd.com/resources-planning-ideas-for-avoiding-irc-1061s-three-year-holding-period-requirement.html

  20. See Tax Reform Progress Report June 2018, Baker Tilly (June 26, 2018), https://bakertilly.com/insights/tax-reform-progress-report-june-2018

  21. IRC §1061(d)(2)(A) & (B). 

  22. See Alexander Anderson, Structuring Carried Interest After U.S. Tax Reform, Bloomberg Tax (Oct. 15, 2018), https://www.omm.com/omm_distribution/tax/structuring_carried_interest_after_US_tax_reform.pdf

  23. Victor Fleischer, Why Hedge Funds Don’t Worry About Carried Interest Tax Rules, N.Y. Times: DealB%k (May 14, 2014), https://dealbook.nytimes.com/2014/05/14/why-hedge-funds-dont-worry-about-carried-interest-tax-rules/

  24. See Lynnley Browning and Miles Weiss, Hedge Fund Managers Shift Billions Over Carried Interest Concern, Bloomberg (May 17, 2018), https://www.bloomberg.com/news/articles/2018-05-17/hedge-fund-managers-shift-billions-over-carried-interest-concern

  25. Cardell McKinstry, Private equity and venture capital firms still digesting Trump tax reform, Atlanta Business Chronicle (May 29, 2018), https://www.bizjournals.com/atlanta/news/2018/05/29/private-equity-and-venture-capital-firms-still.html

  26. See Marie Sapirie, Carrying On With Carried Interest, Tax Notes (Jun. 19, 2018), https://www.taxnotes.com/tax-reform/carrying-carried-interest

  27. IRC §1231(a)(3)(A)(i). 

  28. IRC §1061(c)(2)(B)(i). 

  29. See Adam Lewis, PE hold times keep going up, PitchBook (Nov. 15, 2017), https://pitchbook.com/news/articles/pe-hold-times-keep-going-up

  30. See Jeff Winland, New Tax Reform Carried Interest Rules Could CRE Investors at Odds with Developers (last accessed Oct. 27, 2018), https://www.aprio.com/whatsnext/new-rules-carried-interest-rules-pit-cre-investors-against-developers/?cn-reloaded=1

  31. Alexander Anderson, Structuring Carried Interest After U.S. Tax Reform, Aprio (Oct. 15, 2018), https://www.omm.com/omm_distribution/tax/structuring_carried_interest_after_US_tax_reform.pdf

  32. IRC §1061(b). 

  33. Dolson, supra note 11. 

  34. See Sapirie, supra note 22. 

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Gregg Coughlin