Definition
Carried interest is the share of investment profits paid to the managers of private equity, venture, hedge, and real estate funds, typically around 20% of the fund's gains, as compensation for managing the investment.
How It Works
When the underlying fund profits are long-term capital gains, the manager's carried interest is generally taxed at long-term capital gains rates rather than the higher ordinary income rates that apply to wages. Current law requires a holding period of more than three years for carried interest to receive long-term treatment, longer than the standard one-year threshold for most assets.
Example
A fund manager earns a 20% share of a fund's long-term gains and, having met the three-year holding requirement, is taxed on that share at capital gains rates rather than ordinary income rates.
Who It Applies To
Fund managers and certain key fund employees. For outside investors, carried interest is mainly a cost that reduces their net returns.
Watch-Outs
The characterization has been the subject of long-running political debate, and the extended holding-period rule means short-held gains do not receive the favorable rate.
