What Is the Carried Interest Loophole? 2026 Explainer

Short answer: The "carried interest loophole" is the nickname for the US tax rule that lets fund managers pay long-term capital gains rates, rather than ordinary income rates, on their share of fund profits. In 2026 that means a top federal rate of 20% instead of 37%, provided the fund held the underlying asset for more than three years. Critics call it a loophole; supporters call it standard partnership tax treatment.

The phrase gets thrown around in election campaigns, but the mechanics are narrow and specific. Here's how it works, what has changed since 2017, and where reform proposals stand.

What is carried interest?

Carried interest, or carry, is the GP's share of a fund's profits, typically paid only after LPs get their capital back and any preferred return. In a classic "2 and 20" fund, the 20 is the carry. The management fee (the 2) is separate and taxed as ordinary income. For the full mechanics, see our pillar on carried interest and the worked examples in how to calculate carried interest.

Legally, carry is a profits interest in the fund partnership. The GP receives it in exchange for managing the fund, not for contributing capital. Under long-standing IRS guidance (Rev. Proc. 93-27), receiving a profits interest generally isn't taxable when it's granted, because it has no liquidation value at that point.

Why is it called a loophole?

Partnership income keeps its character as it flows through to partners. When a fund sells a portfolio company at a gain, that gain is a capital gain, and the GP's carry share of it is a capital gain too. So a manager whose main pay is carry can pay capital gains rates on income that critics say is really compensation for services.

That is the core argument. Supporters respond that carry is genuinely at risk, only pays if the fund makes money, and is treated like any other partner's share of partnership gains.

How is carried interest taxed in 2026?

Section 1061 of the Internal Revenue Code, added by the Tax Cuts and Jobs Act of 2017, sets a longer holding period for carry. Gains allocated to an "applicable partnership interest" only get long-term capital gains rates if the asset was held for more than three years. Gains on assets held three years or less are recharacterized as short-term capital gains, taxed at ordinary rates. You can read the statute at 26 U.S.C. 1061 on Cornell LII.

The 3.8% net investment income tax can apply on top for high earners. The 2026 top bracket thresholds come from the IRS's 2026 inflation adjustments: 37% applies above $640,600 of taxable income for single filers, and the 20% long-term gains rate applies above $545,500.

A simplified example: on $1,000,000 of carry taxed entirely at the top rates, the difference between 37% and 20% is $170,000 of federal income tax. Real bills depend on brackets, state tax and the NIIT, so treat this as arithmetic, not a forecast.

Two details that often get missed:

• The GP's own capital is outside Section 1061. If the GP invests its own money in the fund alongside LPs, returns on that capital follow the normal one-year rule.

• Not every gain is caught. The final Section 1061 regulations exclude certain gains, including Section 1231 gains on property used in a trade or business. This is one reason real estate fund managers often see different results from venture and buyout managers.

Venture funds often hold companies for many years, so most venture carry already clears the three-year bar. The rule bites harder on strategies with faster exits. Our comparison of carried interest in venture vs PE covers the differences.

Has the carried interest loophole been closed?

No. Here is the short history:

1. 2017: The Tax Cuts and Jobs Act added Section 1061 and the three-year holding period. It narrowed the benefit but didn't remove it.

2. 2022: An early draft of the Inflation Reduction Act would have extended the holding period further. The provision was dropped before the bill passed.

3. 2025: Despite public calls to end the preference, the One Big Beautiful Bill Act, signed July 4, 2025, left Section 1061 unchanged. It also kept the 20% top long-term capital gains rate.

4. 2026: On April 16, 2026, Senators Wyden, Whitehouse and King introduced the Ending the Carried Interest Loophole Act (S. 4330). It would require fund managers to recognize annual "deemed compensation" taxed as ordinary income. As of October 2026 it has been referred to the Senate Finance Committee and has not advanced.

What would closing it mean for fund managers?

Most reform proposals take one of three approaches: taxing all carry as ordinary income, extending the holding period again, or taxing a deemed annual return as compensation. Any of them would change after-tax GP economics and could shift how managers structure fees, GP commitments and fund terms. None is law today, so current planning runs on the existing Section 1061 framework.

For managers, the practical work is operational: tracking holding periods per asset, separating carry from GP capital in the books, and getting LPs and the GP accurate K-1s. Our carried interest tax primer covers what to ask your tax adviser, and our note on the management fee in VC and PE funds explains the other half of GP pay.

Frequently asked questions

What is the carried interest loophole in simple terms?

It's the rule that lets fund managers pay capital gains tax rates, rather than ordinary income tax rates, on their share of fund profits, as long as the fund held the investment for more than three years.

Is the carried interest loophole still in effect in 2026?

Yes. The One Big Beautiful Bill Act of 2025 did not change Section 1061, and no later bill has become law as of October 2026.

What is the three-year rule for carried interest?

Under Section 1061, gains allocated to carry only qualify for long-term capital gains rates if the underlying asset was held for more than three years. Shorter holds are taxed as short-term gains.

Who benefits from the carried interest loophole?

General partners of private equity, venture capital, real estate and other investment partnerships who receive a profits interest for managing the fund.

Does the carried interest loophole apply to real estate?

Real estate funds use carry too. Some real estate gains, such as Section 1231 gains, fall outside the Section 1061 recharacterization, so results can differ from venture or buyout funds.

Is the management fee taxed as capital gains?

No. Management fees are payment for services and are taxed as ordinary income to the manager.

This article is general information, not tax or legal advice. Tax treatment depends on your facts. Consult a qualified tax adviser.