Section 1061 extended the holding period for long-term capital gains on carried interest from one year to three. If your fund exits a position before the three-year mark, your share of the gain gets recharacterized as short-term — taxed at ordinary income rates that can exceed 50% in California or New York.
But there's an exception baked into the statute that could be overlooked.
If you invest actual capital into the fund alongside your carry, Section 1061(c)(4) excludes that capital interest from the three-year rule entirely. Gains on the money you put in — as opposed to the performance allocation you earned — qualify for standard one-year long-term capital gains treatment. For a GP who co-invests meaningfully, this can shift a significant portion of fund returns into a lower tax bracket, even on early exits.
⚠️ The catch: the IRS requires strict bifurcation. Your partnership agreement must maintain separate capital accounts for your invested capital and your carried interest, with contemporaneous books and records tracking allocations to each. If the two aren't clearly documented, the capital-interest portion may not qualify for the Section 1061(c)(4) exception, causing more of the gain to be subject to Section 1061 recharacterization.
If your fund regularly exits positions in the 12–30 month range, the difference between one-year and three-year treatment on your co-invest could be material. Worth reviewing your partnership agreement with your tax advisor before the next exit.
For educational purposes only. Not tax, legal, or investment advice.