In short
Carried interest is a share of fund profits that managers earn as a performance incentive, typically 20 percent after investors receive their money back and a preferred return. Under section 1061 of the tax code, that carry is taxed as long term capital gain only if the fund held the asset for more than three years. If the holding period is three years or less, the carry is taxed as short term capital gain at ordinary income rates. The top effective federal rate on short term gain is 40.8 percent. Long term gain is taxed at 23.8 percent. 26 U.S.C. § 1(h), 26 U.S.C. § 1411, Russell Investments The One Big Beautiful Bill Act of 2025 did not change these rules. Tax alert The Carried Interest Fairness Act of 2025, which would tax carried interest as ordinary income, with an exception for qualified capital interests, was introduced but has not advanced. Congress.gov S.445, S.445 text Management fees are always taxed as ordinary income.
What is carried interest in an AI infrastructure fund?
A private investment fund usually has two layers of compensation for its managers. The management fee is a fixed percentage of committed capital, often 1 to 2 percent per year. It is always taxed as ordinary income. The carried interest, or carry, is a share of the fund’s profits, typically 20 percent. It is paid only after the fund returns all invested capital and a preferred return, often 6 to 8 percent annually, to its investors. This structure is called a waterfall.
In an AI infrastructure fund, the fund invests in physical assets like AI data centers, fiber networks, energy generation, and related digital infrastructure. The managers source deals, oversee construction, and operate the assets. The carried interest is their main incentive to produce strong returns.
A real example is DigitalBridge Group, a public digital infrastructure asset manager, disclosed in its 2024 annual report that its carried interest represents a disproportionate allocation of up to 20 percent of cumulative fund returns. This is subject to a preferred return of 6 to 8 percent and a clawback if later losses reduce cumulative gains. DigitalBridge 10-K The firm managed about $119 billion in assets as of early 2026 across more than 45 portfolio companies, including Vantage Data Centers and DataBank. DigitalBridge website
The scale of AI infrastructure investing has surged. Global AI data center deal value reached a record $61 billion in 2025. CNBC Private equity firms have invested over $200 billion since 2020 into AI data centers, semiconductors, and energy infrastructure. American Investment Council For fund managers, the tax treatment of carried interest on these deals matters a great deal.
How does section 1061 tax carried interest today?
The 3 year holding period
Under the general tax rule, a gain from selling an asset held more than one year is long term capital gain, or LTCG, taxed at lower rates. I.R.C. § 1222, I.R.C. § 1(h) Section 1061, added by the Tax Cuts and Jobs Act of 2017, creates a special longer holding period for carried interest. If a taxpayer holds an applicable partnership interest, or API, the excess of the taxpayer’s net LTCG with respect to that interest over the net LTCG recomputed by substituting a three year holding period for the one year period is treated as short term capital gain, taxed at ordinary rates. 26 U.S.C. § 1061(a)
In other words, the manager’s capital gain from carry gets the preferred long term rate only when the fund held the investment for more than three years.
What is an applicable partnership interest (API)?
An API is any partnership interest that, directly or indirectly, is transferred to or held by a taxpayer in connection with the performance of substantial services by the taxpayer or any related person in any applicable trade or business (ATB). 26 U.S.C. § 1061(c)(1) This covers fund managers who actively run a fund. An employee of a company that is not in an ATB is excluded, but that is rare in the fund context.
Once an interest becomes an API, it stays an API unless a statutory exception applies. Even retirement does not remove the API label. Treas. Reg. § 1.1061-2 So carry remains subject to the three year rule indefinitely.
What is an applicable trade or business (ATB)?
An ATB is any activity done regularly, continuously, and substantially that consists, at least in part, of raising or returning capital and either investing in or disposing of specified assets (or identifying specified assets for such investing or disposition), or developing specified assets. 26 U.S.C. § 1061(c)(2) This definition sweeps in nearly every private investment fund, including AI infrastructure funds, because they raise capital from limited partners and invest in AI data centers, energy projects, and related assets.
Specified assets include securities, commodities, real estate held for rental or investment, cash or cash equivalents, options or derivative contracts with respect to any of the foregoing, and partnership interests to the extent of the partnership’s proportionate interest in any of the foregoing. 26 U.S.C. § 1061(c)(3) AI data centers and other physical infrastructure fall within real estate held for investment, so they are squarely covered.
How are gains recharacterized?
The recharacterization rule compares the net LTCG actually allocated to the API with the net LTCG that would be allocated if the 1 year holding period in section 1222 were replaced by a 3 year holding period. The excess is treated as short term capital gain. Treas. Reg. § 1.1061-4
The holding period that matters is the direct owner’s holding period. If the partnership sells an AI data center it has owned, the partnership’s holding period in that asset controls. So a fund that flips an AI data center after two years will generate short term gain for the carry, even if the manager personally has held the partnership interest for longer. When a manager sells the API itself, the manager’s holding period in the API controls. Treas. Reg. § 1.1061-4
There is an important exception. Gains that are treated as LTCG under other Code sections without regard to the general holding period rules are not subject to recharacterization. This includes section 1231 gains from depreciable real property and equipment used in a trade or business. 86 Fed. Reg. 5452 Many AI data center sales produce section 1231 gains, so those gains can remain LTCG even if the asset was held less than three years. Qualified dividends and section 1256 contract gains are also exempt. This nuance means the three year recharacterization often applies only to pure capital gain from the sale of fund entities or other assets not covered by section 1231.
The capital interest exception
Managers often invest their own money alongside outside investors. This coinvestment is not carried interest. It is a capital interest. Section 1061 provides that an API does not include a capital interest that gives the holder a right to share in partnership capital commensurate with the capital contributed, or the value of such interest subject to tax under section 83 at receipt or vesting. 26 U.S.C. § 1061(c)(4)(B)
To use this exception, the partnership must allocate income and gain on the capital interest in a similar manner to allocations made to unrelated non-service partners who together hold at least 5 percent of aggregate capital contributed to the partnership. Treas. Reg. § 1.1061-3 The capital interest must be separately identified in the partnership agreement and books.
The regulations impose a hard rule on debt funding. If the manager borrowed the money to make the capital contribution and the loan is made or guaranteed by the partnership, another partner, or a related person, that contribution does not count for the exception. However, if the loan is made by another partner or a related person other than the partnership, the contribution may still count if the loan is fully recourse to the individual service provider, the individual service provider has no right to reimbursement from any other person, and the loan is not guaranteed by any other person. Treas. Reg. § 1.1061-3 This prevents managers from using fund-provided loans to build a capital interest that avoids section 1061.
Also, a manager cannot count unrealized gains in the capital account when measuring whether the share is commensurate with contributed capital. Gains must be realized first. Treas. Reg. § 1.1061-3
The corporate exception
An API does not include an interest held directly or indirectly by a corporation. 26 U.S.C. § 1061(c)(4)(A) However, the IRS has ruled that S corporations do not qualify for this exception, and neither do PFICs with a QEF election. Notice 2018-18, Treas. Reg. § 1.1061-3(b)(2) Only C corporations can use the corporate exception. Some fund managers might hold their carry through a C corporation, but that adds an entity-level tax and often does not save taxes overall.
Transfer and related person rules
If a manager transfers an API to a related person, such as a family member or a colleague in the same fund, the manager must recognize short term capital gain on the excess of the LTCG attributable to the sale or exchange of assets held not more than three years over amounts already treated as short term capital gain under subsection (a), even if the gain on the transfer would otherwise be long term capital gain. 26 U.S.C. § 1061(d) This rule applies only when the transfer itself triggers gain recognition. Tax-free transfers such as gifts do not accelerate gain. Treas. Reg. § 1.1061-5 So estate planning transfers of an API do not automatically trigger tax.
Netting and reporting
A taxpayer with multiple APIs nets gains and losses from all of them at the owner level. Treas. Reg. § 1.1061-4 Each passthrough entity that allocates gain to an API holder must report the necessary information on an attachment to Schedule K-1. Treas. Reg. § 1.1061-6, IRS Section 1061 Reporting FAQs
What are the tax rates and the stakes for managers?
The top federal ordinary income rate is 37 percent, made permanent by the One Big Beautiful Bill Act. PwC The top long term capital gain rate is 20 percent. Fidelity A 3.8 percent net investment income tax (NIIT) applies to net investment income for individuals above $200,000 (single) or $250,000 (joint). I.R.C. § 1411
| Type of income | Top base rate | Top rate with NIIT |
|---|---|---|
| Short term capital gain (ordinary income) | 37% | 40.8% |
| Long term capital gain | 20% | 23.8% |
For a manager who receives $10 million in carried interest, the difference between long term and short term treatment is $1.7 million in federal tax. When a fund holds an asset longer than three years, the manager keeps roughly 76.2 cents of each carried interest dollar after federal tax versus 59.2 cents if the gain is short term. This difference drives fund structuring. Many AI infrastructure funds aim to hold AI data centers and energy assets for three to five years or longer, so the longer holding period aligns with the tax rule.
Management fees are always ordinary income and therefore always taxed at the 40.8 percent top rate. The tax code treats management fees less favorably than long term carry.
What did the OBBBA and the Carried Interest Fairness Act do?
The One Big Beautiful Bill Act of 2025
The OBBBA, signed into law on July 4, 2025, was a large tax and spending bill. It made the 37 percent top ordinary income rate permanent, among many other changes. But it did not include any provision to change the taxation of carried interest. Tax alert So the section 1061 rules remain unchanged.
The Carried Interest Fairness Act of 2025
On February 6, 2025, Senator Tammy Baldwin and Representative Mark Pocan introduced the Carried Interest Fairness Act (S. 445 / H.R. 1091). The bill would add a new Code section that recharacterizes net LTCG allocated to an investment services partnership interest as ordinary income, subject to an exception for gain allocated to a qualified capital interest, with related losses recharacterized as ordinary losses only to the extent of prior ordinary income from that interest. Congress.gov S.445 It would effectively end the capital gain preference for carried interest. The legislation is estimated to raise about $6.5 billion over 10 years. CAGW
The bills were referred to the Senate Finance Committee and the House Ways and Means Committee but have not moved forward. The Managed Funds Association lobbied on the carried interest bills and the OBBBA in 2025. LDA Filing The American Investment Council also lobbied on H.R. 1091 and S. 445. OpenSecrets For now, the current law stands, but reform remains a live topic.
Real examples of AI infrastructure funds at scale
These recent deals show how large AI infrastructure investing has become and why the tax treatment of carried interest is so significant.
- DigitalBridge Group had $35.5 billion of fee earning equity under management and disclosed carried interest of up to 20 percent subject to 6 to 8 percent preferred returns and clawback. DigitalBridge 10-K
- Blue Owl closed its Digital Infrastructure Fund III at the $7 billion hard cap in July 2025. Its evergreen digital infrastructure fund raised $1.7 billion. Fund IV is expected in 2026 with a $9 billion target. With Intelligence
- Stonepeak launched Montera, a North American AI data center platform, with a $1.5 billion equity investment. Stonepeak’s broader AI data center portfolio spans over 100 facilities, with over 500 MW of capacity and 400 MW in development. Chronograph
- KKR and Energy Capital Partners announced a $50 billion partnership to invest in AI data centers and power generation. WSJ
- Blackstone announced a $25 billion AI data center and energy infrastructure investment in Northeast Pennsylvania and separately agreed to acquire the Potomac Energy Center, a natural gas plant in Virginia’s AI data center alley. American Investment Council, Reuters
- Stargate, a joint venture between OpenAI, SoftBank, and Oracle, committed up to $500 billion to AI infrastructure. American Investment Council
- A group including BlackRock, Microsoft, and Nvidia agreed to buy Aligned Data Centers in a deal worth about $40 billion. AP News
What should fund managers watch next?
Three areas to watch.
Potential legislation. The Carried Interest Fairness Act could be reintroduced or folded into a future tax package. The OBBBA did not rule out carried interest change. The lobbying dynamics and political environment make it plausible that the 23.8 percent rate could rise to 40.8 percent for all carry. No bill is active now, but tax counsel should monitor developments.
IRS guidance on enterprise value. Section 1061(b) contains a rule about the sale of an API where the gain is attributable to enterprise value not tied to specific assets. The preamble to the final regulations said Treasury is still studying the section 1061(b) exception and the impact of section 1061 on enterprise value. 86 Fed. Reg. 5452 No further guidance has been issued. This creates uncertainty when a manager sells an entire API, as part of the gain may be recharacterized under the lookthrough rule if the purpose was to avoid section 1061.
Management fee waiver arrangements. Some managers waive a management fee in exchange for a larger profits interest, converting ordinary fee income into carry. Treasury and the IRS proposed regulations in 2015 under section 707(a)(2)(A) that would treat an abusive waiver as a disguised payment for services, but those regulations were never finalized. Practitioners still treat aggressive fee waivers as potentially abusive, so fund managers should be cautious with such structures. Florida Bar Journal
Key takeaways
- Carried interest from AI infrastructure funds is taxed as long term capital gain only if the fund holds the asset for more than three years. A shorter hold makes the gain short term, taxed at ordinary income rates. 26 U.S.C. § 1061(a)
- The top effective rate on short term carry is 40.8 percent. The top effective rate on long term carry is 23.8 percent. The 17 point spread is a powerful incentive to hold assets past the three year mark. Bankrate
- Section 1231 gains from depreciable real property and equipment, common in AI data center sales, are not subject to the three year recharacterization and can remain LTCG even if held shorter. 86 Fed. Reg. 5452
- The capital interest exception can shield a manager’s own coinvested capital, but the manager must use cash not attributable to a loan made or guaranteed by the partnership or another partner (though a loan from another partner, but not the partnership itself, may still qualify if the individual is fully personally liable, has no right to reimbursement, and the loan is not guaranteed by any other person), the partnership must have a 5 percent unrelated non-service capital pool, and allocations must be made in a similar manner. Treas. Reg. § 1.1061-3
- Once an interest is an API, it stays an API, even after retirement. Treas. Reg. § 1.1061-2
- The OBBBA of 2025 did not change carried interest taxation. The Carried Interest Fairness Act, which would tax all carry as ordinary income, has been introduced but not enacted. Tax alert, Congress.gov S.445
- Management fees are always ordinary income, subject to the 40.8 percent top rate. There is no holding period play for management fees.
- Fund managers should monitor carry waiver enforcement, enterprise value guidance, and potential future legislation.
Frequently asked questions
Q:What is the difference between management fees and carried interest?
A:Management fees are fixed annual payments, usually 1 to 2 percent of committed capital, that the manager receives for operating the fund. They are always taxed as ordinary income. Carried interest is a share of the fund’s profits, typically 20 percent, earned only after returning all invested capital and a preferred return. Under current law, carry can be taxed at the lower long term capital gain rate if the three year holding period is met. 26 U.S.C. § 1(h), 26 U.S.C. § 1061
Q:What holding period determines whether my carried interest gets long term capital gain treatment?
A:The holding period of the direct owner of the asset. If the partnership sells an AI data center, the partnership’s holding period in that AI data center controls. If you sell your partnership interest, the API, your holding period in the API controls. Treas. Reg. § 1.1061-4 So you must look at who is selling what.
Q:Does the One Big Beautiful Bill Act of 2025 change anything for carried interest?
A:No. The OBBBA made the 37 percent top ordinary rate permanent and included many other tax changes, but it did not alter the taxation of carried interest. Tax alert Section 1061 remains in effect.
Q:What is the Carried Interest Fairness Act?
A:It is a bill introduced in the Senate (S. 445) and House (H.R. 1091) in February 2025. If enacted, it would treat net capital gain allocated to an investment services partnership interest as ordinary income, not capital gain. Congress.gov S.445 The bill has not advanced beyond committee referral.
Q:Can I use a corporation to hold my carried interest and avoid section 1061?
A:Only a C corporation is eligible for the corporate exception. S corporations and PFICs with QEF elections are not. Notice 2018-18, Treas. Reg. § 1.1061-3(b)(2) However, a C corporation adds double taxation. The corporation pays tax on its income, and you pay tax on dividends or salary. For most managers, that is not tax-efficient.
Q:What happens to my section 1061 status when I retire from the fund?
A:Once a partnership interest is an API, it stays an API unless a statutory exception applies. Retirement does not remove the API tag. Treas. Reg. § 1.1061-2 Your carry remains subject to the three year rule for any future gains allocated to you.
Q:What is the similar manner test for the capital interest exception?
A:The capital interest exception requires that allocations on your coinvested capital be made in a similar manner to allocations for unrelated non-service partners whose combined capital contributions equal at least five percent of the aggregate capital contributed to the partnership. Treas. Reg. § 1.1061-3 The capital interest must be separately identified and allocations must be reasonably consistent across the group.
Q:Can I use unrealized gains in my capital account to qualify for the capital interest exception?
A:No. The regulations require gains to be realized before they count toward the capital interest exception. Treas. Reg. § 1.1061-3 You cannot rely on paper gains to boost your capital contribution.
Q:Does the 3 year rule apply to all gains from an AI data center sale?
A:Not necessarily. Section 1231 gains from the sale of depreciable real property or equipment used in a trade or business are not subject to recharacterization under section 1061. 86 Fed. Reg. 5452 That means many AI data center real estate sales already produce LTCG without meeting the three year test. Gains that are not section 1231 gains, such as gain on the sale of partnership interests themselves, are still subject to the three year rule.
Q:Are management fees taxed the same as carried interest?
A:No. Management fees are compensation for services and are always ordinary income, taxed at the top rate of 37 percent plus the 3.8 percent NIIT. There is no holding period that can convert management fees to capital gain.
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Junde Liu, JD, LL.M. (Taxation) candidate at UF Law. Originally published on Compute Law Blog. This article is general information and does not constitute legal advice. Reading it does not create an attorney client relationship. The reader should not act on the basis of any content here without first consulting a licensed attorney in the relevant state. Last reviewed for accuracy May 23, 2026.