My QOF sat 60% in cash through two testing dates, and I ate the drag

Gain was $265k from selling my share of a small equipment business in 2022. I rolled it inside the window into a two-asset QOF run by a regional sponsor, $250k in, rest of the gain I paid tax on.

The plan on paper was a 42 unit infill build and a converted warehouse, both in the same tract. The warehouse went away in month five (seller took a better offer) and the sponsor never replaced it. So the fund held my money in a money market while it hunted, and it blew through two semiannual asset tests with roughly 60% of assets in cash. There's a working capital safe harbor that's supposed to cover cash held under a written plan for a project, and the sponsor's plan covered the deal that died, not the money sitting there waiting for a new one. The fund got hit with a penalty at each testing date. My share was about $4,100 total, which honestly isn't the wound.

The wound is the 2% management fee charged on committed capital from day one. Four years, $250k, $20k of fees for a period where maybe half my money was in dirt. Then last year I needed liquidity for a different reason, redeemed, and that redemption is an inclusion event, so the deferred gain came due and the ten year appreciation exclusion I was buying went in the bin.

What I'd do differently: I'd fund on capital calls tied to named assets under contract, and I'd ask to see the written working capital plan for each project before wiring, not the marketing deck. Also I'd stop treating a tax benefit as a reason to lock money I might need. Confirm any of the safe harbor mechanics with your own tax person, mine caught the penalty pass-through before I did.

Answer

2monica_tran3SF4CPRO6

tally, the diligence question that would've caught it isn't about the tax code at all, it's about the funding mechanics.

Two things I ask now before any subscription. First, is capital called against named assets that are under contract or closed, or is it drawn upfront into a blind pool? Upfront funding means the sponsor's fee clock starts on your whole check while the deployment risk stays yours. Call-based funding pushes that risk back where it belongs. Second, ask for the written working capital plan for each project, the actual document, plus who at the fund is responsible for updating it when a deal changes. That plan is what supports holding cash without failing the asset test, and it's project-specific, so a plan written for a warehouse that died doesn't cover money hunting for a replacement. Whether any given fund's plan actually holds up is a question for a tax attorney, not for me or for the sponsor's IR person.

The $4,100 penalty is a rounding error next to $20k of fees on lazy capital and then losing the ten year clock entirely on redemption. If your liquidity picture had any chance of needing that money before year ten, the whole structure was fighting you from the start. I've turned down two funds purely on the fee-on-committed language and I don't regret either.

4 replies

2omar_haddadActivePRO11

The dead second asset is the part I'd chase. On the construction side a sponsor who loses a deal in month five and can't backfill in a whole year either had no pipeline or lost their lender's appetite. Did they ever tell you which one it was? I've watched a GP sit on cash for three quarters because the bank repriced the construction loan and the deal no longer penciled, and nobody said that out loud until a quarterly call where somebody asked directly.

1dpatel_reCS4A

Agreeing with thatch on mechanics, disagreeing on where the cost sat. Run it as a drag calculation instead of a penalty story. Four years, half of $250k parked at cash yields inside a fund charging 2% on the full commitment, against the same money in the build it was supposed to be in. That gap is most of your loss and it happened before anyone failed a test. The test failure was a symptom.

Separately, most subscription docs I've read let the manager charge on commitments through the investment period whatever the deployment pace is. If you can't negotiate that (you usually can't as a $250k LP), then deployment pace is the single number you underwrite, and the only honest evidence is their last two funds: dollars called vs dollars in the ground by quarter. Ask for it. If they won't produce it, that's your answer.

1chriswalton8CC1CPRO8

Went back over this a second time. So the fund can be penalized for holding cash and the LPs absorb it through NAV, and separately the LP can trigger their own tax event by exiting early? I'd assumed the tax stuff all sat at the fund level until year ten. That's two different clocks running and I hadn't separated them in my head at all.