If you don't know what Section 1061 is, you're probably paying more in taxes than you need to.
If you do know what it is, you're probably stressed about it.
Either way, let's talk about the tax code section that quietly controls a significant portion of your financial life.
The 30-second version
Section 1061 is the part of the tax code that governs how carried interest is taxed. It was added in 2017 as part of the Tax Cuts and Jobs Act, and it essentially says:
For carried interest to qualify for long-term capital gains treatment (20% federal rate), the underlying investments must be held for at least 3 years.
If the investments are held for less than 3 years, your share of the gains is taxed as short-term capital gains — which means ordinary income rates (up to 37% federal).
That's a 17 percentage point difference. On a $1M distribution, that's $170,000 in additional taxes.
So yeah, it matters.
Why this exists
For decades, carried interest was taxed at long-term capital gains rates regardless of how long the fund held its investments. This was controversial — critics called it the "carried interest loophole" because fund managers were getting favorable tax treatment on what was essentially compensation for their labor.
Section 1061 was the political compromise. It didn't eliminate favorable treatment for carry, but it added a holding period requirement: 3 years instead of the standard 1 year for long-term capital gains.
Whether this is fair policy is above my pay grade. What matters for you is understanding how it works and planning accordingly.
What counts as the holding period
Here's where it gets nuanced.
The 3-year holding period applies to the underlying assets, not to your carry. This means:
If your fund buys a company in January 2023 and sells it in February 2026, the holding period is ~3 years. Your carry from that deal qualifies for long-term treatment.
If your fund buys a company in January 2023 and sells it in December 2024, the holding period is ~2 years. Your carry from that deal is taxed as ordinary income.
The calculation is done deal-by-deal within the fund. A single fund might have some exits that qualify for long-term treatment and others that don't.
Your K-1 should break this out. Look for the distinction between "Section 1061 adjustment" amounts and regular capital gains. If you don't see this breakdown, ask your fund's tax team.
The holding period starts when
The clock starts when the fund acquires the asset, not when you receive your carry allocation.
This seems obvious but creates confusion. If you join a fund mid-investment-period, you get credit for the holding period that occurred before you arrived. If the fund bought a company 2 years before you started and sells it 2 years after, that's a 4-year hold — even though "your" hold was only 2 years.
Conversely, if you leave a fund but retain your vested carry, the holding period keeps running based on when the fund acquired the assets.
Capital interest vs. profits interest
This is the technical distinction that matters most.
Profits interest (which is what carry typically is): Subject to Section 1061. Needs the 3-year holding period for long-term treatment.
Capital interest (a direct ownership stake in the fund's capital): NOT subject to Section 1061. Regular 1-year holding period applies.
Why does this matter? Some funds structure a portion of GP compensation as capital interest rather than profits interest. If you've made a cash investment in your fund (your "GP commit"), gains on that portion follow normal capital gains rules — 1 year for long-term treatment.
This is why your GP commit matters beyond just having skin in the game. It's a portion of your fund exposure that isn't subject to the 1061 3-year rule.
What your fund's tax counsel memo says (summarized)
Every fund has a tax memo on 1061 compliance. It's probably 40+ pages. Here's what actually matters:
The fund is tracking holding periods. Your fund administrator should be calculating which exits qualify for 1061 long-term treatment and which don't.
Your K-1 will reflect the breakdown. You'll see some gains reported as long-term capital gains and some as short-term (or with a 1061 adjustment that recharacterizes them as short-term).
There's no magic. You can't personally do anything to change the holding period of an investment. The fund holds it as long as it holds it. Your only lever is understanding the tax treatment and planning your overall tax picture accordingly.
Common mistakes
Mistake #1: Ignoring the breakdown on your K-1
Not all carry is taxed the same. If you're just looking at the total distribution and assuming it's all long-term capital gains, you might be underestimating your tax liability significantly.
Mistake #2: Not coordinating with other income
In years when you have a lot of 1061-adjusted gains (taxed as ordinary income), you might want to defer other income or accelerate deductions. Your tax picture across all sources matters.
Mistake #3: Forgetting state taxes
1061 is federal tax law. Your state may or may not follow it. Most do, but some states have their own quirks. If you're in a high-tax state (California, New York, New Jersey), the combined federal + state rate on short-term gains can exceed 50%.
Mistake #4: Not asking questions
If you don't understand your K-1, ask. Your fund's tax team deals with these questions regularly. Your personal accountant should understand 1061 as well — if they don't, consider whether they're the right accountant for your situation.
What you can actually do
Understand your exposure. Look at your fund's portfolio. Which investments have been held more than 3 years? Which are approaching 3 years? This gives you a rough sense of how future distributions might be taxed.
Plan for the worst case. When estimating taxes on future carry distributions, assume some portion will be short-term. Better to be pleasantly surprised than to have a tax bill you didn't expect.
Maximize your GP commit. Within your financial capacity, a larger GP commit means a larger portion of your fund economics flows through as capital interest rather than profits interest. That's not subject to 1061.
Work with advisors who understand this. Your CPA should know 1061 without you having to explain it. Your wealth advisor should understand how carry taxation affects your planning. If they don't, you need different advisors.
The bottom line
Section 1061 isn't going away. There's periodic political noise about changing carried interest taxation further, but for now, the 3-year rule is the law.
Your job is to understand it, plan around it, and make sure your advisors understand it too. The 17 percentage point difference between long-term and short-term rates is too significant to ignore or misunderstand.
Next week: Talking to your spouse about carry (without starting a fight).
Talk soon.