What is the three-year rule for carry?

It was added by the 2017 tax law and applies to tax years beginning after December 31, 2017. It covers an applicable partnership interest: one held in connection with substantial services in a business of raising or returning capital and investing in, or developing, assets such as securities. Gains on assets held more than one year but not more than three are recharacterised as short-term, which is taxed at ordinary income rates for individuals.

Say a fund sells a company after two years and a manager’s share of carry on the gain is $10 million. Because the holding period is under three years, the $10 million is short-term capital gain; after four years it would be long-term. Simple example. Terms vary by fund.

It ties the tax on carry to how long a fund holds each asset, so the timing of exits around the three-year mark has a tax cost for managers.