Section 1061 Rules for Carried Interest Capital Gains

Section 1061 of the Internal Revenue Code modified the taxation of “carried interest” for investment professionals in private equity, venture capital, and hedge funds. Historically, these professionals could receive a share of fund profits, known as carried interest, that was taxed at lower long-term capital gains rates if assets were held for over one year.

The rule establishes a longer holding period requirement to qualify for the preferential long-term capital gains rate. The assets generating the gain must now be held for more than three years. If this threshold is not met, the gains are recharacterized as short-term capital gains and are subject to higher ordinary income tax rates. This change targets the compensation structure common in the alternative asset management industry.

Defining an Applicable Partnership Interest

An “Applicable Partnership Interest,” or API, is any interest in a partnership that is transferred to or held by a taxpayer in connection with performing substantial services. These services must be rendered in an “Applicable Trade or Business” (ATB), which is a business that regularly involves raising or returning capital and investing in or developing specified assets.

Specified assets include items such as:

• Securities
• Commodities
• Real estate held for rental or investment
• Cash or cash equivalents

This definition encompasses the typical activities of private equity, real estate, and hedge funds.

The regulations provide exceptions that prevent a partnership interest from being classified as an API. The primary one is the “Capital Interest Exception,” which applies to returns based on a partner’s contributed capital rather than services. To qualify, allocations to the service partner’s capital account must be reasonably consistent with those made to other significant, non-service partners.

Another exclusion applies to interests held by an employee of a business that is not an ATB. An interest held by a C corporation is also excluded from the definition of an API, though this exception does not extend to S corporations or certain Passive Foreign Investment Companies (PFICs).

Recharacterization of Long-Term Capital Gains

Holding an API can lead to the recharacterization of capital gains from two primary sources. The first is the partner’s share of the partnership’s gain from the sale of its assets. The second is the gain a partner recognizes from selling their own API if they have held the interest for three years or less.

The calculation of the amount to be recharacterized is determined at the taxpayer level. This “Recharacterization Amount” is the difference between the taxpayer’s net long-term capital gain from their APIs under the standard one-year holding period and the net long-term gain calculated using a three-year holding period. The holding period of the underlying asset sold by the partnership is the determining factor, not how long the partner has held their partnership interest.

Not all types of income are subject to this recharacterization. The rules do not apply to certain categories of income, even if associated with an API. These include:

• Qualified dividend income
• Section 1231 gains from the sale of real or depreciable business property
• Section 1256 gains from certain regulated futures and options contracts
• Other capital gains characterized without regard to standard holding period rules

These income types retain their original character for tax purposes.

Special Rules and Considerations

The tax code includes provisions to address transactions that could otherwise be used to circumvent its main purpose. One such provision governs the transfer of an API to a related party, such as a family member or a controlled entity. If a taxpayer transfers an API to a related party, it can trigger the immediate recognition of short-term capital gain on underlying assets held for three years or less.

Another provision is the “look-through rule,” which applies to certain dispositions of APIs held for more than three years. This rule is designed to prevent avoidance of the three-year holding period requirement in tiered partnership structures. For instance, if a partner sells an API in a fund they have held for over three years, but the fund itself primarily holds assets for less than three years, this rule may apply.

The look-through rule can recharacterize the long-term gain from the sale of the API into short-term gain, based on the holding periods of the underlying assets in the partnership. This prevents a partner from realizing a long-term capital gain on the sale of their interest when the underlying investments would not have qualified. The rule applies if a transaction’s principal purpose was to avoid the recharacterization rules.

Reporting and Information Requirements

Compliance imposes reporting duties on both partnerships and partners holding APIs. The partnership is responsible for providing its partners with the necessary information to calculate any gain recharacterization, which is required to be attached to the Schedule K-1 (Form 1065).

The partnership must furnish details that distinguish between gains subject to the three-year holding period and those that are not. This includes disclosing long-term capital gains from assets held for three years or less versus more than three years. The partnership must also provide information on amounts that are excluded, such as gains attributable to a partner’s capital interest.

Using the information provided by the partnership, the individual partner is responsible for calculating the final Recharacterization Amount. The IRS has provided specific worksheets that taxpayers must use to determine the amount of gain to be recharacterized as short-term. This worksheet helps aggregate information from all APIs the taxpayer may hold. The partner must attach the completed worksheets to their income tax return, such as Form 1040, to substantiate their calculations.