Disguised sale of a QOZ partnership interest

Editor: Anthony Bakale, CPA

The tax benefits of qualified opportunity zone (QOZ) investments have attracted a wide array of participants into the program. Several structural issues arise when a QOZ project involves using both private developer capital and third-party investor equity.

180-day problem

Taxpayers can elect to defer capital gain from the sale or exchange of property as long as that gain is invested within 180 days from the date the gain is recognized into a qualified opportunity fund (QOF) (Sec. 1400Z-2(a)(1)). The default date on which the 180-day investment period begins is the date the gain is recognized, but if the gain is recognized by a passthrough entity (PTE), an individual owner/investor in that entity has additional options for when the 180-day investment period begins. The PTE owner/investor can elect to use any of the following dates to start the 180-day period: the PTE’s gain date, the last day of the PTE’s tax year, or the original due date of the tax return for the PTE reporting the gain.

Once the QOF receives an investment, it then has to invest at least 90% of its assets in QOZ property (QOZP), which includes QOZ stock, QOZ partnership interest, and QOZ business property; otherwise, the QOF may be subject to penalties (Sec. 1400Z-2(d)(2)). In general, the QOF self-certifies its compliance with the 90% test on the last day of the first six-month period of the fund’s tax year and its last day of the tax year (Sec. 1400Z-2(d)(1)).

Developers will use their own capital as well as capital from third-party investors to fund QOZ projects. The decision whether to bring third-party equity into a development project is generally made 12 to 24 months into the project’s development. The timing of the 180-day rule for the developer and the subsequent 90% investment test may force them to contribute their cash into a QOF and then invest it into a QOZ business (QOZB) before third-party investor equity can be raised. The subsequent raising of third-party equity can result in an overfunding of a particular project and force the developer to withdraw a portion of its original funding. The contribution by the investors and subsequent withdrawal by the developer may be viewed as a disguised sale of the property or interest.

Disguised sale of property

If the developer brings third-party equity into the QOZB within 24 months of the date of the contribution by the QOF into the QOZB, the developer may find itself in a position where the additional equity has now overcapitalized the project and the excess capital needs to be distributed back out to the developers. Whenever there is a contribution of property or cash into a partnership and distribution out of property, including cash, during a 24-month period, consideration needs to be given to whether the disguisedsale rules apply.

Regs. Sec. 1.707-3 states that a transfer of property by a partner to a partnership and one or more transfers of money or other consideration by the partnership to that partner may be treated as a sale. Regs. Sec. 1.707-3(c) states a transfer of property to a partnership and the partnership’s transfer of money or other consideration to the contributing partner within two years are presumed to be a sale. The determination whether the disguised-sale rules apply is a facts-and-circumstances analysis.

This analysis is pivotal to QOZ transactions because for a partnership interest to be a QOZ partnership interest, it has to be acquired by the QOF after Dec. 31, 2017, directly from the QOZ partnership solely in exchange for cash. If the contribution and distribution transaction were recharacterized as a sale, it would fail to meet the definition of a QOZ partnership interest. This is because, as a disguised sale, the acquisition by the third-party equity investors would not be deemed to be directly from the QOZ partnership, and the QOF no longer has “good property” for purposes of meeting the 90% test.

Example: Assume that in 2023, Developer A contributes $1 million to QOF A in exchange for an LLC interest within 180 days of its capital gain event. QOF A then contributes $1 million to QOZB A in exchange for an LLC interest within six months of QOF A’s electing to be treated as a QOF. Initially, Developer A was going to fund 100% of the equity for the project, but a year after making the equity investment into QOF A, Developer A decides to raise third-party capital. In 2024, QOF B contributes $500,000 to QOZB A in exchange for an LLC interest. Since the project was overfunded, QOZB A distributes $500,000 of cash back out to QOF A as a return of capital, reducing QOF A’s interest in QOZB A. QOF A plans to redeploy the cash received into another QOZB, allowing it to continue to meet the 90% test. If the contribution by B and distribution to A are recharacterized as a disguised sale of property or a partnership interest, then QOF B would not hold “good property” and would fail to meet the 90% test. 

Arguments against disguised-sale treatment

The above transaction should not be characterized as a disguised sale of a partnership interest under Sec. 707 due to lack of regulatory authority and a lack of tax avoidance, and Regs. Sec. 1.1400Z2(d)-1 does not refer to a disguised sale of a partnership interest as a disqualifying purchase of a partnership interest.

Lack of regulatory guidance: There is no guidance in the Internal Revenue Code or the regulations regarding a disguised sale of a partnership interest. On Nov. 26, 2004, the IRS issued Prop. Regs. Sec. 1.707-7 addressing disguised sales of partnership interests (REG-149519-03). On Jan. 21, 2009, the IRS withdrew Prop. Regs. Sec. 1.707-7 (74 Fed. Reg. 3,508).

Lack of tax avoidance: The preamble to Prop. Regs. Sec. 1.707-7 stated that the legislative history of Sec. 707(a) (2)(B) indicates the provision was adopted as a result of congressional concern that “taxpayers were deferring or avoiding tax on sales of partnership property, including sales of partnership interests, by characterizing sales as contributions of property, including money, followed or preceded by related partnership distributions.” Tax avoidance would be necessary for the recharacterization rules in Prop. Regs. Sec. 1.707-7 to apply.

If third-party equity is purchasing a QOZB interest at the same value for which the QOF purchases its LLC interest, even if the transaction were viewed as a disguised sale of a partnership interest, there would be no gain or loss on the transaction. Because there is no gain or loss on the transaction, there is no tax avoidance, and there would be no policy reason to recharacterize the transaction as a sale.

Interplay of Regs. Secs. 1.1400Z2(a)-1 and 1.1400Z2(d)-1: Regs. Sec. 1.1400Z2(a)-1(c)(6)(iii)(A) (1) states that to the extent the transfer of property to a QOF partnership is characterized as other than a contribution, under Sec. 707 and the regulations thereunder, such recharacterization as a sale is not treated as being made in exchange for a qualifying investment.

Regs. Sec. 1.1400Z2(a)-1(c)(5)(iii) states that an eligible taxpayer may invest in a QOF by acquiring an eligible interest in a QOF from a person other than the QOF, provided that all of the requirements of Sec. 1400Z-2(a)(1) and the Sec. 1400Z-2 regulations for making a valid deferral election with respect to that investment are otherwise satisfied with respect to the acquisition. Regs. Sec. 1.1400Z2(a)-1(c)(5)(iii) thus would allow a cross-purchase as an eligible interest, as long as the interest was an eligible interest in the hands of the seller.

Both Regs. Sec. 1.1400Z2(d)-1(c) (2)(ii)(A) and Regs. Sec. 1.1400Z2(d)-1(c)(2)(ii)(B)(1) treat redemptions by a corporation of stock within certain periods not as QOZ stock. Regs. Sec. 1.1400Z2(d)-1(c)(3)(i), which deals with QOZ partnership interests, does not contain the same restriction as that on redemption of corporate stock.

Since there is no relevant direct reference to Sec. 707 in Regs. Sec. 1.1400Z2(d)-1 and no restriction on redemptions with respect to acquisitions of QOZ partnership interests, a recharacterization of the contribution by the third-party investors as a sale under Sec. 707 should not apply.

This is an area where the IRS should provide additional regulations. The lack of regulations under Sec. 707 regarding a disguised sale of partnership interest and the failure of the QOZ regulations to address short-term funding of QOZ project costs via developer funding creates uncertainty in common business situations where short-term funding is replaced by long-term equity contributions.

Editor Notes

Anthony Bakale, CPA, is a tax partner with Cohen & Company Ltd. in Cleveland. For additional information about these items, contact Bakale at tbakale@cohencpa.com. Contributors are members of or associated with Cohen & Company Ltd.