The Carried Interest Loophole: What High-Income Investors Should Know

The carried interest loophole is a controversial tax rule that lets private equity, venture capital, and hedge fund managers pay lower capital gains tax rates on income that would normally be taxed as regular compensation. For ultra-wealthy investors in alternative assets, knowing how this loophole works — and when it might close — could mean the difference between significant tax savings and a costly surprise.

Here are the key things you should know about the carried interest loophole:

• Current tax advantage: Fund managers pay just 20% capital gains tax on carried interest versus 37% ordinary income rates.
• Political momentum building: The loophole faces unprecedented bipartisan pressure in 2025, with key members of both parties both pushing for elimination.
• Direct impact on investment returns: Changes could affect fund manager incentive structures and performance dynamics of private investments.
• Portfolio strategy implications: Managers might accelerate sales or adjust fee structures to maintain after-tax returns.
• Revenue generation: Closing the loophole could raise $6.5–18 billion over ten years for other tax priorities.
• Industry resistance: Private equity associations spent $710,000 in Q1 2025 alone lobbying to preserve the current treatment.
• Timing uncertainty: Implementation details, grandfathering provisions, and effective dates remain unclear.

At Avidian Wealth Solutions, our experienced team stays ahead of evolving tax legislation to help ultra-high-net-worth clients optimize their investment strategies and plan to preserve their wealth through changing regulatory landscapes. Schedule a conversation with us today to discuss how potential reforms might affect your portfolio and explore proactive strategies in this evolving environment.

What is the carried interest loophole?

The mechanics of carried interest trace back to 16th-century maritime trade, where ship captains received 20% of profits for successfully delivering cargo to foreign ports. Today’s investment funds operate on a similar principle, with general partners earning their carried interest allocation — typically 20% of profits above a predetermined hurdle rate — on top of annual management fees. Under current tax law, this compensation qualifies as a capital gain if the underlying investments are held for more than three years.

The tax distinction is substantial: while management fees face ordinary income rates up to 37%, carried interest receives preferential 20% capital gains treatment and avoids the 15.3% self-employment tax. Critics argue this creates an artificial benefit since fund managers are compensated for professional services using other people’s money, not their own capital investments. The original policy rationale for lower capital gains rates was to encourage individual investment risk-taking, not to subsidize professional management fees.

Note that while there is no capital gains tax in the state of Texas, investors are responsible for paying capital gains at the federal level.

Who benefits from the carried interest loophole?

The carried interest provision primarily benefits a relatively small but exceptionally wealthy group of investment professionals. General partners at private equity firms, venture capital funds, hedge funds, and real estate investment vehicles are the primary beneficiaries.

While the loophole doesn’t directly benefit investors like pension funds or endowments — who actually pay the carried interest fees out of their return — it does indirectly affect the broader alternative investment ecosystem that many ultra-high-net-worth individuals participate in through fund investments, co-investments, and secondary market transactions. 

This is because the tax advantage helps attract and retain top fund management talent, potentially enhancing fund performance, while also influencing fee structures and hurdle rates across the industry.

What to know about the carried interest tax deduction

Reform efforts are accelerating

Unlike previous reform attempts that fizzled out in committee, as of 2025, the current push has gained unprecedented traction with lawmakers from both sides of the aisle introducing specific legislation. The difference this time is the bipartisan nature of the effort and the pressing need to find revenue sources for extending other tax cuts. Even traditionally supportive Republican lawmakers are reconsidering their stance as the political cost of defending Wall Street tax breaks becomes harder to justify to their constituents.

Your investment returns could be affected

Changes to carried interest tax treatment could fundamentally alter how fund managers structure deals and time exits. 

Consider this carried interest example scenario: a private equity fund that has historically held portfolio companies for five years to maximize tax benefits must reevaluate their timeline — they imagine it will shrink significantly if managers lose the incentive to hold for capital gains treatment. Additionally, some managers may demand higher carried interest percentages to offset the increased tax burden, potentially reducing net returns to limited partners.

Fund strategies may shift

Expect significant changes in how funds approach investment management services and portfolio construction. Managers may increase their own capital contributions to deals, allowing them to maintain some capital gains treatment on their personal investments while paying ordinary income rates on their management fees. This shift could lead to more selective deal-making, higher co-investment minimums, and potentially better alignment between general and limited partners’ interests.

It’s a revenue target

The carried interest loophole represents low-hanging fruit for lawmakers seeking to fund other priorities without broad-based tax increases. With an estimated $6.5–18 billion in potential revenue over ten years, it’s an attractive target that polls well across party lines. However, this revenue would primarily come from a small group of ultra-wealthy individuals, making it more of a symbolic victory than a major budget solution, which may actually increase its likelihood of passage.

The industry is fighting back

Private equity and hedge fund associations are deploying sophisticated investment risk control measures to protect their interests, including extensive lobbying campaigns and strategic campaign contributions. Their argument centers on the claim that carried interest represents entrepreneurial risk-taking rather than simple compensation — but the industry faces an uphill public relations battle.

Implementation timeline remains unclear

The complexity of tax optimization strategies around carried interest means that even if reform passes, the implementation details will be important. Key questions include: 

• Would changes be grandfathered for existing funds?
• How would they interact with other partnership tax rules?
• What transition periods might apply?

Wealth managers are closely monitoring these developments to help clients prepare for various scenarios, as the timing and structure of any changes could significantly impact planning strategies for high-net-worth investors with alternative investment allocations. The treatment of realized capital gains from existing carried interest positions remains particularly uncertain, making proactive planning essential.

Stay ahead of tax policy shifts with strategic planning from Avidian Wealth Solutions

The potential elimination of the carried interest loophole represents just one of many evolving tax policy challenges that ultra-high-net-worth investors must plan for in today’s complex regulatory environment. Whether these proposed changes pass as-is, stall on the floor, or get revised, the uncertainty highlights why it’s essential to work with experienced wealth advisors who grasp both the fine print and the bigger picture of tax reform.

At Avidian Wealth Solutions, we partner with sophisticated investors across Houston, Austin, Sugar Land, and The Woodlands to help them develop comprehensive strategies that can adapt to changing tax landscapes while preserving and growing wealth. We monitor legislative developments closely and work with clients to implement flexible structures that work to withstand regulatory changes.

The carried interest debate is far from over, and the final outcome will likely shape alternative investment strategies for years to come. Rather than waiting for certainty that may never arrive, schedule a conversation with our wealth management team to discuss how potential tax reforms might impact your specific situation.

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