Overview
Qualified Opportunity Funds (QOFs) offer generous tax incentives but are bound by a complicated set of rules, not to mention the complexity of Subchapter K of the Internal Revenue Code (IRC), as QOFs are typically organized as partnerships for tax purposes.
A common misconception among tax practitioners is the belief that debt-financed distributions from QOFs within two years of funding are prohibited. Many cite Internal Revenue Service (IRS) regulations and accompanying guidance as justification for this view, claiming such distributions trigger a “disguised sale,” thereby nullifying the tax benefits of the QOF. However, while regulations exist that could impact debt-financed distributions in limited circumstances, the foundational disguised sale rules – well-established in US tax code for decades – remain unchanged.
In Depth
THE BENEFITS OF INVESTING IN QOFS
Before diving deeper, let’s explore the compelling benefits of investing in a QOF by making a “qualifying investment”:
- Deferral of Capital Gains: If you reinvest capital gains from the sale of assets (like real estate or stocks) into a QOF within 180 days, you can defer paying federal capital gains tax until your tax year, including December 31, 2026.
- Tax Reduction: Investments made before December 31, 2021, can reduce your capital gains tax by 10% upon recognition, and those made before December 31, 2019, can see a reduction of 15%.
- Permanent Exclusion: Perhaps the most attractive benefit, by holding your investment in a QOF for 10 years or more, you can permanently exclude any gains from federal taxes, including depreciation recapture.
THE RISKS OF DEBT-FINANCED DISTRIBUTIONS
Despite these enticing benefits, caution is essential. Engaging in debt-financed distributions to achieve liquidity can lead to significant tax consequences. When an investor contributes eligible gains to a QOF, the investor’s initial tax basis in that investment is zero. Any cash distribution exceeding this zero basis could trigger detrimental outcomes, including the loss of QOF benefits and immediate taxation on deferred gains.
However, certain events can increase a partner’s tax basis in a QOF. For example, when deferred gains are recognized on December 31, 2026, the partner’s basis increases by the amount of the eligible gain contributed. Additionally, debt incurred by the QOF can be allocated to partners, potentially allowing them to receive cash without jeopardizing QOF benefits.
Partnership interest tax basis reflects the amount the partner has invested, adjusted for various factors such as additional contributions, distributions, and share of partnership debt. It is important because it determines the extent to which distributions can be taken tax-free and helps calculate any gain or loss when the partner disposes of their partnership interest.
When a QOF incurs nonrecourse debt, that debt is typically allocated among the partners according to their ownership interests under IRC Section 752. This allocation increases the outside basis for each partner by the amount of debt allocated to them. For example, if a QOF takes on a $1 million loan and a partner has a 50% interest, that partner’s outside basis typically will increase by $500,000.
Debt-financed distributions occur when a QOF distributes cash or property to its partners that is funded by such borrowed money. Because the partner’s share of the debt increases their outside basis, these distributions can often be received by the partner without triggering a taxable event.
For instance, if a partner initially contributes $100,000 of eligible gain in cash to a QOF, their outside basis will start at zero. If the QOF subsequently incurs debt of $200,000 and allocates $100,000 of that debt to the partner, their outside basis will increase to $100,000. If the partner then receives a distribution of $80,000, the receipt of the distribution may not be taxable because it does not exceed the partner’s adjusted basis.
Now, let’s clarify the regulations surrounding debt-financed distributions. A disguised sale occurs when transactions that are ostensibly a contribution followed by a distribution are treated by the IRS as a sale for tax purposes. Under Treas. Reg. § 1.707-3, if a distribution occurs within two years of contributing “other property” (non-cash property), it may be presumed to be a disguised sale. However, cash contributions do not fall into the “other property” category and are treated differently. Therefore, when cash is the property contributed to a QOF, there is no straightforward “disguised sale” issue. Additionally, Treas. Reg. § 1.707-5(b) includes rules for avoiding disguised sale treatment for debt-financed distributions.
Yet, caution is still warranted. The QOF must navigate “inclusion event” rules carefully. If a distribution’s fair market value exceeds a partner’s outside basis, this triggers an inclusion event, leading to negative tax implications. However, if a distribution is debt-financed, the allocation of debt can instantaneously increase a partner’s basis, mitigating some risks.
UNDERSTANDING THE DISGUISED SALE “SUPERCHARGE RULE”
The disguised sale “supercharge rule” (Treas. Reg. § 1.1400Z2(a)-1(c)(6)(iii)(A)(2)) is a complex but crucial component of the regulations surrounding QOFs. This rule highlights how contributions to a QOF can be impacted by how those contributions are characterized under the tax law.
Generally, under Treas. Reg. § 1.1400Z2(a)-1 (the “deferral regulation”), the amount of capital gain that is eligible for deferral is subject to a special rule for QOF partnerships. The regulations stipulate that, to the extent a transfer would be characterized as other than a contribution (citing an IRC Section 707 disguised sale as an example), the transfer is not treated as made in exchange for a qualifying investment under Treas. Reg. § 1.1400Z2(a)-1(c)(6)(iii)(A)(1). In other words, if a QOF member made a contribution that was recast as a disguised sale, the QOF interest that the member took in exchange is not a qualifying investment and is not entitled to the tax benefits described above. The regulations go further in the supercharge rule and say that if any transfer to the QOF is not treated as a contribution, in whole or part, then the portion of the transfer to the partnership that is not recharacterized will not be a qualifying investment to the extent that it would have been characterized if the disguised sale under Section 707 were broadened by making the following two “supercharging” modifications:
- Any cash contributed is treated as “other property”
- In the case of a debt-financed distribution, the partner’s share of liabilities under Section 752 is treated as zero.
This second modification eliminates the benefits of a debt-financed distribution but only if the supercharge rule is initially triggered.
Therefore, even a small, disguised sale can lead to a big problem, because the remaining contribution is subject to the disguised sale supercharge rule. However, if no part of a contribution is recast as a disguised sale under the general tax rules, then the supercharge rule is not implicated. Even though debt-financed distributions are not necessarily part of a disguised sale, many tax practitioners think that any debt-financed distribution made within the two-year presumption period is prohibited.
In our view, this interpretation is overly conservative, providing an unnecessary impediment to liquidity from QOF investments. Investors seeking liquidity should instead apply the traditional disguised sale analysis before deciding whether to proceed with a debt-financed distribution.
CONCLUSION
Navigating the complexities of QOFs requires careful attention to detail, particularly regarding debt-financed distributions and outside basis calculations. While the benefits of investing in QOFs are substantial, a thorough understanding of the associated regulations and potential pitfalls is essential for maximizing those benefits. By staying informed and seeking relevant guidance, investors can protect their interests and leverage the unique opportunities presented by QOFs.
If you have questions or need assistance navigating the complexities surrounding claiming debt-financed distributions from QOFs, please contact your regular McDermott lawyer or one of the authors of this article.
