Troy Merkel, Partner at RSM, joined us on the podcast to discuss everything investors need to know about Opportunity Zones.
In January 2018, Troy was selected as a senior analyst in RSM’s cutting edge Industry Eminence Program, which positions its senior analysts to understand, forecast and communicate economic, business and technology trends shaping the industries RSM serves. These senior analysts advise clients on conditions impacting middle market leaders. Troy’s focus is on the real estate industry.
Troy has 15 years of experience in audit and consulting, with a particular emphasis in real estate and financial services reporting, in accordance with US GAAP, IFRS, NCREIF PREA Reporting Standards and income tax basis. Troy also advises his clients on technology solutions tailored for the real estate industry.
He provides audit and consulting services to development, operating and investment real estate entities featuring all asset classes and types, from initial ground-up construction through disposition. He has extensive real estate valuation experience. He is also an expert in accounting for asset acquisitions and complex leases. In addition, he specializes in various tax-advantageous and government subsidized deal structures.
Troy’s financial services background involves audits of private equity funds, which hold equity or debt interests in a variety of industries including technology, consumer products, personal services, real estate and renewable resources. His expertise includes complex valuations, mezzanine and first lender analysis, as well as, the evaluation of options.
Tyler Stewart - All opinions expressed by Adam, Tyler and podcast guests are solely their own opinions, and do not reflect the opinion of RealCrowd. This podcast is for informational purposes only, and should not be relied upon as a basis for investment decisions. To gain a better understanding of the risks associated with commercial real estate investing, please consult your advisors. Hey, listeners, Tyler here. Before we start today's episode, I wanted to quickly remind you to head to realcrowduniversity.com to enroll into our free six-week course on the fundamentals behind commercial real estate investing. That's realcrowduniversity.com. Thanks.
Adam Hooper - Hey, Tyler.
Tyler Stewart - Hey, Adam, how are you today?
Adam Hooper - Good, we're coming with a sneak attack here.
Tyler Stewart - Yeah, special release.
Adam Hooper - Special release mid-week episode.
Tyler Stewart - Yes.
Adam Hooper - We thought this was topical enough, and we partnered with one of our friends from RSM on the podcast today to talk about opportunity zones.
Tyler Stewart - That's right, we had Troy Merkel, partner at RSM, which is a top five accounting firm here in the U.S.
Adam Hooper - Yeah, so we've even done several webinars with Troy and the folks over at IMS, also RSM. Bunch of letters there. Maybe some of our listeners have caught those, but opportunity zones are something that's very, very much in the news right now. It's a huge tax incentive to invest in certain geographical areas that have been designated. Most of the coverage that we've seen and we'll talk about in the show today has been focused more on the manager side and how to comply with the rules, so we thought we'd take a little while to talk with Troy about what does it mean from the investor perspective. If you're someone that has capital gains that wants to take advantage of these opportunity zones, what does that look like for you and what are some of those things that you should be thinking about as you look at potential investments in opportunity zones.
Tyler Stewart - Absolutely. One of the keys with opportunity zones is there's a whole timeline for when you have to invest and how long you have to invest. Troy dove deep into those details, and just kind of gave us a good overview of the timeline of investing into opportunity zones.
Adam Hooper - Again, still early in the regulations. We feel we'll see a lot more activity here as we round out the year and turn the corner to 2019, so definitely stay tuned for a lot more information from us on this. If you're a subscriber of the show, we'll be sending out a survey here shortly to take the temperature and kind of gauge the interest of our listeners and of our audience of what the interest is in investing in these opportunity zones. If you're not yet a subscriber or you're not a member of RealCrowd, head over to realcrowd.com. Login, create an account there, just simple email address, and we'll be sure to get you included in the survey, and then you can be part of our research. With that, wish everybody a happy Thanksgiving. Enjoy the holiday, and we'll get to it.
RealCrowd - This podcast is brought to you by RealCrowd, the leader in online real estate investing. Visit realcrowd.com to learn more about how we provide our members with direct access to commercial real estate investments. Don't forget to subscribe to the podcast on iTunes, Google Music or SoundCloud. RealCrowd, invest smarter.
Adam Hooper - Well, Troy, thanks for joining us today. I believe you're back in Boston this evening, but we appreciate you jumping on the podcast with us to talk about the ever-exciting opportunity zones.
Troy Merkel - Thanks for having me. Freshly back to Boston from New York.
Adam Hooper - Perfect, well, why don't you take a minute, tells us a little bit about RSM, what you do there. Kind of your overall involvement in what's going on in the opportunity zone world. Then we can just dig right in to the meat of the conversation.
Troy Merkel - Absolutely. RSM's a public accounting and consulting firm. We're the fifth largest firm in the United States. Focused across all the traditional services you'd expect, audit and tax, and we also do a fair amount of technology consulting, deal consulting and realty, or real estate, specialty consulting. Myself, I'm a partner in our real estate practice. As part of my role, I'm in what we consider our Industry Eminence Program. What that means is that I'm focused on the real estate industry and helping to advise our clients and help the public with issues regarding macroeconomic and market trends, policy changes, such as the opportunity zones, and also technology trends that are impacting the real estate industry.
Adam Hooper - Good, and we've done a couple webinars together recently. I'm assuming some our listeners have probably heard those, so we're excited to jump back into opportunity zones today. I'm sure this'll be the first of many conversations we have on the space with you guys.
Troy Merkel - Absolutely. Definitely a hot topic that I think every time we're talking to anyone, no matter what we're talking about, the first question is, we could be talking about blockchain, they raise their hand. Well, what about opportunity zones? It's like, all right, fine, fair enough, let's move that way.
Adam Hooper - Here we go. I think we want to preface the conversation with a lot of the content that's out there right now, a lot of the media coverage is more focused on the compliance side or the regulatory side, or if you're a real estate manager, how to structure your fund and how to deploy the capital. We would like to focus today, if we can, on how opportunity zones look through the lens of a potential investor, someone that has, which we'll talk about, someone that has those capital gains to invest into an opportunity fund project. Some of the mechanics, some of the things to look out for and just generally why they would do that. I think let's just start super high level. Maybe this is the first time someone, a listener's, hearing about an opportunity zone or opportunity fund. Take us from 50,000 foot. What's an opportunity zone? What's an opportunity fund?
Troy Merkel - Absolutely. An opportunity zone is an area that they've been designated by the local state governor. They are generally low-income housing or low-income household tracts of land, census tracts, although there can be low-income tracts adjacent areas. One of the first surprises when this came out is the locations that many of these governors picked were already areas that were kind of poised for development in those regions. In particular, when you look at some of the ones that were allocated in L.A. County, Nashville, Denver, even Long Island in New York was selected and Brooklyn. Hot off the presses, Amazon picked Long Island to be one of the... Location of their HQ2. I wonder if they're going to be taking advantage of some of the opportunity zone structures and benefits. These opportunity zones were designated. The idea was that the politicians wanted to really drive economic growth in these zones and bring back jobs and bring development into these depressed areas. What it is is that if you open a new business or invest in real estate or any other business in one of these opportunity zones, where the majority of your assets and at least 50% of your income
Troy Merkel - for the new business would be coming from one of these opportunity zones, you have a chance to defer the gain of any capital gain that you may have recognized in one of your other businesses or one of your other investments. As long as you invest that gain or select that gain to be deferred within 180 days of when it would be recognized, you can defer that gain up until the date of sale, or 2026, whichever comes first, at which point you have to pay tax on the gain. It actually gets even better than that in some ways because if you are going to hold the investment for five or seven years, after five years you get a 10% reduction in that capital gain. If you hold it for seven years, you get an additional 5% reduction in the capital gain. It's really incentivized. There's even more benefits if you're going to hold it longer, which I'm sure we'll talk about. But it's a really great tax planning tool for the investors. That is one of the things we talk a lot to real estate companies that are looking to take advantage of it, but also I've been getting several calls from investors, clients that have recently sold family businesses or have had large capital gains based off of stock portfolios. They're looking to do some tax planning with those gains. We've been talking to them about these opportunity zones and how they can be really good investments prior to being designated as opportunity zones, and now can be fantastic investments now that they've been designated as opportunity zones.
Adam Hooper - That's one of the things that we've seen from both investors and managers out there is that, and we've talked about it on the show before, that you don't want to let the tax tail wag the dog. The underlying real estate opportunity is not going to go from something that doesn't pencil to this phenomenal project overnight because of this opportunity zone designation. What we've seen and what we've been hearing is it can make an already good project potentially that much better. It's not going to be enough to potentially, at least not that we've seen, to take projects that wouldn't happen in a normal capital markets environment and maybe allow those to happen, although maybe it can, I don't know. What's your take on that?
Troy Merkel - That's good, sound investment advice. You always want to have the fundamentals of the real estate property stand on its own, without any sort of tax incentive or tax benefit. The concept of tax incentives or benefits, historically, or similar programs have been new markets or historic tax credits or even low-income housing tax credits. Oftentimes, those deals are underwritten at a very razor-thin margin, and you are writing those deals to get the tax credits. I think with these opportunity zones, especially with how early we are in the stage of this investing, everyone that we're talking to that's establishing a fund or has an investment opportunity, when they're pitching it to their investors, they're really still pitching it as a real estate deal in that any of the tax benefits that those investors are going to realize because of it being an opportunity zone, that's really just gravy on top of that. That's what we're seeing with the initial deals. I think that's because there were so many of these locations that already had development coming. We're still kind of at the point of getting low-hanging fruit, really. We haven't dove into where a lot of these investments go deeper. You will potentially start to see investments that might be a little bit thinner in the margins of whether or not the deal will get done, and being in an opportunity zone might push it over the edge. We might see some of that. We also might see opportunities where not traditional real estate investors may take advantage of creating entity structures.
Troy Merkel - If it's a manufacturing company or a technology company that's looking to expand and has a significant capital outlay, they need to take a larger footprint, they want to build out a new facility, they may be looking to also take advantage of those, and those might be thinner margins, as well, because it's more of a business case need than it is specifically a real estate investment need.
Adam Hooper - Again, just for purposes of this conversation, we'll probably try to stay focused more on the real estate side, just because I know there's still some clarity that needs to be put forth by Treasury on how some of those nuances in the business investing side of the world come together. Maybe that's been some of the criticism of this first round of regulation that we got from Treasury was it feels like it's still either yet to be determined or maybe even a little bit prohibitive for how a business investment can comply with this, whereas I think we have a lot more clarity on the real estate side as to how to apply this sooner than later, pending additional clarification from Treasury.
Troy Merkel - Absolutely. The real estate investment community's going to be the first, and one of the larger, beneficiaries of the opportunity zone because it just marries up. It's as if a real estate investor wrote all the regs themselves. Five, seven, 10-year hold periods? That's awfully familiar.
Adam Hooper - It does, doesn't it? Let's kind of take a step back. Again, we've talked about this a little bit on the show before, but I would imagine that's a number of listeners out there that their eyes have already glazed over. This can be a pretty complex subject. First up is this 180-day window. Similar to a 1031 exchange, you have a period after which you've sold the property, you trigger that gain. There's this 180-day window that an investor has to basically earmark these gains for investing into an opportunity fund. Is that correct?
Troy Merkel - That's correct, yes.
Adam Hooper - Any event that triggers recognition of that gain applies? Is it all gains? It is just capital gains?
Troy Merkel - It has to be a capital gain. You can't have an ordinary income. It was very clear that it's a capital gain. There was some ambiguity when the regs first came out, but a couple of weeks ago when we got some further clarification, they made sure to say that it has to be a capital gain. You have 180 days. That gain, there's some questions about, well, what if it's a partnership that are recognized as a gain? There is some nuance there. Either the partnership could elect to defer that gain, or the individual partners could elect to defer that gain. There's some, not necessarily ambiguity, but nuance there as to when the partners know that there's a gain to be elected. If they aren't aware, then they don't actually have to make that election until they've been made aware through their K-1 filing. There could be some extenuating circumstances where that 180 day might stretch out a little bit, especially if those gains are coming up through a partnership or something of the like.
Adam Hooper - That's interesting. We can maybe dive into that in a little bit. Most of the investments that are made on, certainly our platform and platforms like it, are not eligible for a 1031 exchange. It's an investment in an LLC. That whole LLC as a entity could do an exchange, but if the individuals want to take some cash out or if they want to go their separate ways, oftentimes that's not available for a 1031 exchange. For investors that are receiving gain from their investments on platforms like ours or others, does this open up an opportunity for them to defer that gain as they would similar to a 1031 exchange?
Troy Merkel - As long as it would qualify as a capital gain, based off their tax position, then they would be able to utilize this to do an opportunity zone investment, unlike they wouldn't be able with a 1031 exchange. There is a lot of confusion sometimes that goes between how is this any different than a 1031? There's other aspects to it that it is a very different program than the 1031 exchange program.
Adam Hooper - To, again, kind of further peel back that onion there, one of the differences between a 1031 is that you can take out your original basis in the investment. With a 1031, you got to put it all, right? You can't take out the basis, or you can, but you're going to have to pay boot, pay tax on it.
Troy Merkel - You're usually not walking with cash from the deal, whereas with these opportunity zones, you could because you really don't have to invest the gain piece of it in order to recognize the benefit, which is nice for the investor.
Adam Hooper - If I bought 50 grand of Amazon stock forever ago, and I sell that now for a million dollars, I can invest any portion of that $950,000 of gain. I could take that 50,000 back in my pocket. Much more flexibility versus a 1031, and also it doesn't have to be real estate. 1031s, part of this tax bill was restricting that specifically to real estate. Opportunity zones, the gain could be from anything, as long as it's a capital gain, right?
Troy Merkel - Absolutely. The gain could be from anything and the investment could be anything. I know we're going to stay focused on real estate, but it does open the door to a broader gamut of investments. There's also, 1031s are really a deferral, for the most part, whereas the opportunity zones do have some of that forgiveness of the gain. Then ultimately, if you hold the investment long enough, you can walk away tax free with the disposition of that investment.
Adam Hooper - Do we know yet, in terms of depreciation recapture at the end of the sale, maybe we'll talk about that later, but have we got clarification on that? If it has to be any kind of recapture there, depreciation recapture? Is that just all wiped at the end of the 10 years?
Troy Merkel - We haven't gotten any specific clarification, but I think, for the most part, the community believes that would get wiped, as well. It would be a true non-tax event. We're hoping that, the IRS has stated they still are expecting to bring further guidance, hopefully at the end of this year, although I'm not holding my breath. I'm expecting it more Q1 of 2019. They may address that. There are still some open questions, but for the most part, the investment community got their questions answered, and people are moving full tilt ahead.
Adam Hooper - That's one of the things that we've seen. There's a lot of announcements out there that groups are raising a hundred million, $250 million, 1/2 a billion dollar funds, billion dollar funds, which is great, but I think, again, who's actually going to invest in these things? The composition of that capital, or the persona of that capital, it's going to be pretty interesting profile. It's someone that has a capital gain. In our case, for this conversation, someone that's comfortable investing in real estate with a longer term horizon, at least the five to seven years to get that initial benefit, and potentially even 10-plus years. I'd be curious to get your take on just composition of that capital that will be investing into these. Have you guys done any research or do you have any feel? I know there's $6 trillion of capital gains out there that's eligible, but where does the majority of that reside or what's the persona of investor that's going to be taking advantage of these opportunity funds?
Troy Merkel - Unlike you would see in a lot of real estate investments, where institutions are driving a lot of the equity, most of the institutional investors aren't coming into the space. What we're seeing is high net worth, family offices, some funds that are rollover capital and gains. That's where it's really coming from, especially the high net worth and the family offices. That's where we're seeing the vast majority of the equity come from. Most funds that are getting structured are setting themselves up so that they can kind of let each of those levels of investors getting involved. Most are looking for accredited investors, but they're allowing thresholds that are sometimes lower than you would typically see for a real estate fund. I'm seeing them as low as 50 to $250,000 entry of equity, which is generally considered lower, on the lower end. You see some of that in the crowdfunding space, but on the traditional PE real estate investing, that's on the lower end. But to capture all these gains because it really is open to anyone with capital gains. They've kind of spread that out. We're still seeing other, larger scale investment funds that are asking from anywhere from a five to $10 million initial ask, but it really is open to a much wider investor pool. The real estate community's really excited to introduce these investors that may not have been traditional real estate investors into the platform and into the benefits of investing in real estate and taking advantage of this opportunity zone tax benefit.
Adam Hooper - That was one of the questions that we got earlier on and we've had to clarify a few times is that there's nothing in this opportunity zone regulation that allows or prohibits a particular kind of investor, whether accredited, non-accredited, qualified purchaser or institutional. That's more of a securities issue and it's a related issues, rather than anything particularly with the opportunity zone. If there's an opportunity out there that's doing it under Reg CF or Regulation A plus or a fully registered offering with the SEC, certainly the opportunity for non-accredited investors to participate in these, as well.
Troy Merkel - Absolutely. We're even seeing high net worth investors or family offices that are looking to go into their own individual investments. You're right, you don't have to be accredited. Some of the fundraising elements are seeing that, but not all the opportunity zones are going to be held exclusively for accredited investors. It really is an open platform. It's a program that kind of unlocks in the benefits of doing good, in some ways, giving back to the economy and trying to grow these areas that need the help. It's lowered some of the barriers to entry that have been there historically for these types of tax-incentive programs to do that type of investing.
Adam Hooper - Well, now that's another good question there that, again, we've been asked, and I don't know that there's an answer for it yet necessarily, is what systems or programs or structures are in place to actually monitor whether this does any good? Or is it going to be another just maximize the tax benefit for those that can? As long as you stay within the letter of the law, spirit be damned, we're going to go take advantage. How are these going to be monitored for the effectiveness of getting capital to work in these communities that it's designed to go into?
Troy Merkel - That's a great question and it's one we see a lot. I actually have had several conversations here, being located in Boston, I've talked to some of the state regulators in Massachusets that they're not the biggest fan, somewhat, of some of this program, primarily because these types of tax credit incentives had historically been, while they were federal credits, they had been allocated to the states, and the states got to select, basically through a lottery system plus an analysis of your development, who could get these, the benefits of these credits. But really, this is a self-certifying program. There's a Form, 949, that needs to be filed with the tax return and everything, but outside of reporting back to the IRS there, it is going to be difficult to track. They'll be able to see where development's happening and where people are taking advantage of it, but how many jobs it creates, how much economic growth it brings outside of the investment itself and the revenue generated by that individual business, that remains to be seen. It will be interesting. I'm sure the regulators will want to measure it. I'm sure most politicians, local and federal, will trumpet it if it is successful. We are seeing actually several states are investing in consultants to help promote this concept of bringing in the opportunity zone investors. Think of it as a lesser degree of we talked about HQ2, what some of the cities were doing there to woo Amazon to their city. This is at a much smaller level, but states are trying to woo investors
Troy Merkel - and developers into their areas now.
Adam Hooper - What you mentioned there, a lot of the prior tax incentive programs, whether it's low-income housing credits or new market tax credits, those are unbelievably complex structures, and requires your 100% sole focus and expertise to be able to comply with that. Do you feel that opportunity zones, opportunity funds, are going to be easily understood by investors? Again, there's some complexities in here that people that aren't used to dealing with these kind of issues might get intimidated by, and we're very early on in the education. A lot of why we're having this conversation today is to try to help bring understanding to what the benefits are and how it can function. But do you feel this is approachable from a normal, quote, unquote, "normal" investor? That they don't have to get a master's thesis in tax planning to figure out how the heck to put money to work in one of these things?
Troy Merkel - No, it's definitely a much more approachable. When you compare it to the hurdles you have to go in through, like a low-income housing or a new market tax credit or even a historic tax credit deal, we are significantly lower threshold, significantly lower levels of compliance and understanding. There's an entire cottage industry of specialists and consultants just to help you get through those tax credit deals, and those have been known for quite some time. The opportunity zones, we're definitely seeing experts coming in and helping people with it. I do recommend that you have an expert help you go through the tax situation. But the hurdles to get into the investment, to track the investment, are substantially lower. In many ways, they're even lower than what you would see historically for some REITs, too. REITs have some quarterly compliance to make sure that they're meeting all the threshold and staying in compliance with what their restrictions are. Opportunity zones, those requirements are semi-annually to make sure that the investments are still located in an opportunity zone, that the income's still being derived from those opportunity zones. Really, outside of those requirements and this two-page self-certification form, there's not a lot more for the investors to do. Also, understanding the benefits of the program, it is pretty well structured. I've seen one-page slides that can kind of walk you through that five year, seven year and 10 year benefits to the opportunity zone. Outside of that, it acts and plays
Troy Merkel - like every other investment. There's a few nuances to it, but you can really reap some significant tax benefits as an individual investor without having to get a master's degree in taxation.
Adam Hooper - We've put together an investor guide, and you guys have come out with some great stuff on the new regs and your reactions to that. We'll link all that in the show notes for people that want to dig in and do a little bit of reading there. I'm an investor. I've got this gain from either my business that I just sold or the gains that I've seen in the stock market. I have a liquidity event, and now I'm sitting at a huge tax bill I don't want to pay. How do I actually invest in one of these?
Troy Merkel - You can decide whether or not you want to go it on your own and create your own quality, qualified opportunity zone fund, or you can partner up with any of the funds that are being raised and get connected there. Let's say you get connected with one of the funds that are being raised. You have that 180-day window to declare that you're going to invest those capital gains. Then at that point, the fund itself actually, one of the great clarifications that came out of the regulations in late October was that there's a 31-month safe harbor now. That was critical because as the regs were originally written, it was basically six months, at most, that you would have had once your money was invested into the fund in order to invest in the qualified opportunity zone business or real estate. That's a very quick turn for this industry. It's very hard to identify an asset, invest in that asset, and then also, we haven't talked about it, but if you're investing in an asset that you're not going to change the purpose of that asset, you have to invest to substantially improve that asset. We can talk a little bit about that, but when the regulations came out, they actually expanded the safe harbor for 31 months, and what that says is that the capital you put in, so let's say we have that million dollar gain, that million dollar gain, as long as you've earmarked it for a qualified opportunity zone investment and you have a written plan as to how you'll be utilizing those funds, then you have 31 months to actually carry through with that investment,
Troy Merkel - which helps open up the spectrum of investments that you can do. You're not going to get rushed into bad deals, hopefully, just because you're trying to get the investment in. That was a critical element to the new regulations that really helps the investor get going. Once you've done that investment, there are some other things to it. If you're new to real estate investing, the laws of real estate is often leveraged, for instance. What we're seeing is there's this timeline, this horizon, to get your equity into the fund. You might actually invest in the fund, and the fund might actually do an all-equity deal to buy a piece of real estate. That way, you've invested your capital gain in time. But then also take out debt, and they can actually distribute out some of that debt so you have a debt finance distribution and actually get some cash out of the project right away. You can continuously get cashflow. If you're new to real estate investing, one of perks of real estate investing is that you oftentimes are getting cashflow without having a taxable event because of some of the depreciation losses and things like that that shelter that income, or shelter that cashflow. This isn't a case where you are going to be putting your money away in an investment and you're not going to see any cash out of that investment until you sell it. You should be expecting cashflow from any investment that you're doing with the real estate here and one of these real estate funds. You should be expecting cashflow during the hold period of the investment.
Troy Merkel - Now that, if you do end up becoming a taxable event, or if the depreciation's not enough to shelter the income, you will get taxed on ordinary income coming from your investment, if there were to be some. It's not as often that that happens, especially early on in a real estate deal, but I do want to make that clear 'cause some people get confused. They think, "Oh, I defer the gain and I never pay any tax on this investment ever." Well, if there is ordinary income from that opportunity zone business, you would pay tax on that. It's more of a capital gain in the investment play.
Tyler Stewart - Got it. Then could you break down the timeline for me? I have a million dollar capital gain. I have 180 days to sign a written commitment towards the deal. Then once I sign that, there's 31 months to deploy that capital? Is that right?
Troy Merkel - Pretty much. You have 180 days to declare that that is going to be, and yeah, a written commitment of that and actually invest the cash. The cash would be transferred into the fund within that 180-day window. We're advising our clients, even if you've identified. Because while 31 months is clearly a lot longer than six months, you want to pick up as much time as you can and give your investor platform or yourself, if you're going to try to self-direct this investment, time to identify these real estate assets. Again, you don't want to make investment in a bad deal hoping that this will make it good. Take your time to find those good deals. If you have that capital gain, you sell your business, or right before you're selling your business, and you're talking to your financial planner or accountant or tax advisor, you should start looking at if I want to take advantage of an opportunity zone, start evaluating those opportunity zones, start evaluating those investments, and use that 180-day window. The self-certification's a fairly quick process. We're advising our clients to wait at least until 175 days or so. Give a few days to get everything lined up, but there's no need to rush that. You can start teeing up the investments, getting ready to make those investments, then put your capital into the fund. Then you start that 31-month window, as long as you have a written plan of how you're planning to allocate those funds to opportunity zone businesses.
Adam Hooper - Now let's talk a little bit. You mentioned the kind of DIY route or the partnering with a manager route. One of the things that, and I guess maybe this is a little bit of a segue into getting a bit nerdy on the actual regs and some of the tests, we've got the 90% test, and then we have the substantial improvement requirement, which basically says that within, again, if you're not changing the use, within a 30-month period of acquiring the asset, you have to increase the basis, you have to improve the basis of that property by 100%, right?
Troy Merkel - Right.
Adam Hooper - The new regs from Treasury clarified that for real estate purposes, that only applies to the building value, not the land value, which is a huge clarification for the real estate space. But that still means that there's going to be a relatively heavy lift included with this. It's not where an investor can buy an apartment complex that's in an opportunity zone, and just operate a stabilized asset. There needs to be a fairly heavy lift, making a substantial improvement. Go figure, that's why they called it that. To spend equal the amount of the money that's currently in the basis of that asset. Where do you see the required real estate expertise for people that are going to try to go DIY this? Do you think there will be a lot of, again, non-professional real estate investors trying to DIY this? Or is that just going to be too complex, and should look to partner with someone that has that skillset, has that expertise that can actually execute on this project?
Troy Merkel - We're see some investors do the DIY. That's more when you're looking at some of, for instance, some of the single family. If they're buying a tract, a single family, or they're going to renovate, do some renovations where they have some construction background, and you definitely want to make sure, you're right, you're going to have to make a significant investment or improvement, unless you're going to reposition the asset. In that case, or repurpose the asset, you're most likely going to need zoning changes if you were going to take, historically, for instance, a warehouse, a worn-out warehouse, and you're now going to make it lofts, which is a pretty popular trend in residential real estate right now. Going through that zoning process will take quite some time. You do have this ticking clock. Most likely, people are going to keep the original use, and just substantially improve it. Again, where a lot of these areas are, there's either undeveloped or underutilized land that may or may not have an existing building on it, but most likely, that's building's not the highest and best use of that property. There's going to be substantial construction. If you're somebody who's not familiar with that, any of my clients, even my traditional real estate investors, as we've come to the later end of the cycle, I actually think these opportunity zones are going to extend the cycle even further. But where they're looking to all the sudden get into development deals and they've historically been a core cashflow investor, I always brace them
Troy Merkel - for make sure you have the expertise on hand. Construction and development is a very different animal than just buying cash flowing property. It's very different. There's a lot more risks to hedge. That's why any investor that's doing that, they're looking usually for better returns. Banks are also going to look at, they're going to be a little more conservative with any sort of development 'cause there's just risk. Things happen with construction. I've never talked to anyone doing a construction deal where everything came in on time
Tyler Stewart - or on budget. That just doesn't happen, even when you're doing home construction. My wife can blow a home construction budget like no other.
Adam Hooper - Hopefully she doesn't listen to the podcast. You mentioned a couple different uses. Say, if you're buying a couple single-family homes, you're buying warehouse conversion play, there is a restriction on the sin-based businesses. Are there any other restrictions on use of the assets? Someone that's looking at these, what are the restrictions on what the capital can be actually invested in?
Troy Merkel - No, it really is just the sin businesses, as far as we're aware. There may be some clarification on that. Again, your sin businesses are your standard sex-related trades, liquor stores, gun stores, and also golf courses.
Adam Hooper - As a former golf pro, before real estate, how is a golf course or a country club considered a sin business?
Troy Merkel - I haven't quite figured that out.
Adam Hooper - You've seen me play.
Tyler Stewart - That's true. No comment.
Troy Merkel - Which one of these doesn't belong, I feel.
Adam Hooper - Outside of those, real estate can be, again, it can be for housing, it can be industrial, it could be retail, it could be office, it could be distribution, it can be whatever.
Troy Merkel - Absolutely, yeah, it can be. All asset classes qualify.
Adam Hooper - Okay. How much gain can be deferred and how long can they be deferred for?
Troy Merkel - You can defer as much gain as you have, or as little gain. Going back to your example there, I think you hit it big with your $50,000 investment in some technology stock, and you got a million dollars out of that. One of the other perks is, when you look at it compared to other benefits, is you don't have to invest all of that gain. Any gain that you want to defer, you do have to invest, but you could invest 1/2 a million dollars in that scenario, or up to $950,000. As long as you have the gains to be deferred, you can invest. Another thing, actually, one of the recent questions we had from a client is a client was disposing of an asset in which they were going to get a forgiveness of debt situation with some old real estate. Oftentimes with a forgiveness of debt, you do have a capital gain event. However, you're not going to walk with cash. The gain is actually that you no longer owe that debtor the money. The question was, well, can I use that gain? The answer is yes. There's no tracking of the cash. It's really just a tracking of the gain. As long as you designate the gain towards this qualified opportunity zone business within the 180 days and it qualifies as a capital gain based on your tax position, you can take advantage of it. Again, no limit to the gains. The number, you threw it out earlier, that everyone sees is about $6.1 trillion of expected gains, capital gains, to be coming. That's just based off of what the IRS is seeing in trends and analysis. Whether or not that number is true, we'll see, or all those gains come to fruition
Troy Merkel - and get invested into the opportunity zones, but no limit on the gains. There's no limit at any level, actually, within even the state or things like that, where historically some of these benefits, like tax credits, in the past, there was always a limited amount allocated each year to each state. There is none. This can really be a boon for capital development, economic development and real estate investors.
Adam Hooper - Perfect. Now once I invest that gain, I've hit this 180-day window, my money's at work. I don't have to pay taxes on that gain until I either sell my interest in the fund or the end of 2026. That's correct?
Troy Merkel - Correct.
Adam Hooper - Okay, now what if I invest in a fund, and that fund buys property, they improve it and they sell that property? If there's cash that comes back up into the fund, is that going to trigger any gain for me?
Troy Merkel - Not necessarily. The fund has the ability to recycle that cash or reinvest that cash into other qualified opportunities to own businesses. If it's a fund that's already invested in some other real estate. Oftentimes, these funds, while they create single-purpose entities underneath, they might have other investments. They can transition some of that cash into those investments. That is something that we're looking for clarification for, how long do you have to reinvest that cash within the fund. It is made very clear in the recent round of regs that the IRS considered and believed that it's reasonable for you to reinvest those funds without triggering the capital gain being recognized by the individual investors, but we don't know, does that reset the 31 month or where does that get us? They've said that they acknowledge that that's something they need to address. We're hoping that'll happen by the start of 2019. Fortunately, I think very few investors are planning on flipping these properties within the next 45 days, so hopefully we'll have the regs back by then. But I guess maybe some aggressive investors might try to do that, but I think we should have the answer before that becomes a problem. With any types of funds like this, where there's some sort of tax incentive, the managing members of those funds are highly cognizant of these, and they don't want to blow that for their investors. They're going to be tracking that. It is their responsibility to track everything that happens within the fund. It is the responsibility of those individual investors to keep track
Troy Merkel - of their capital gains that they're deferring. I'm sure the investment advisors will help you with that, but it is ultimately their responsibility. We're seeing many of the funds say that in the upfront, that it's your responsibility to have, one, deemed that your money that you're bringing in here is earmarked to a capital gain, and also that it's your responsibility to keep track of your own capital gains. Because otherwise, it would just get unwieldy for the investment community.
Tyler Stewart - Does this change the tax reporting an investor would do during the hold of the asset? Are they still getting a K-1? What's that look like?
Troy Merkel - They would still be getting a K-1. They would be notified. There wouldn't be any real changes there. There would be the additional reporting forms that the opportunity zone fund would be doing, kind of self-certifying that they have made those opportunity zone investments.
Adam Hooper - Now we've got the money to work. You mentioned there's a reduction in the gain. We'll go back to our example. For round numbers, we'll say we have a million dollars of gain that we've invested.
Troy Merkel - Sure.
Adam Hooper - If I invest by the end of 2019, which is kind of the end of that window to get the full benefit from the step up in basis, if I hold that investment for at least five years, I'm only going to owe tax on 900,000 of that gain?
Troy Merkel - Right.
Adam Hooper - Then if I hold it for the full seven years, I'm only going to owe tax on 850,000 of that million dollar gain?
Troy Merkel - Absolutely.
Adam Hooper - That's not just a temporary deferral, right? That is a full on reduction of the basis?
Troy Merkel - Full on forgiveness.
Adam Hooper - Forgiveness of that, up to 15%, which is pretty impactful.
Troy Merkel - Absolutely. One of the other things, so when you look at that, too, from the real estate investment, and when we're talking to people on how the cashflow works, and we talked about that leveraging. Let's say your million dollar example, let's say you decide, you know what? You're trying to weigh the option. I'm going to pay my tax and I'm just going to live with it in the year that I get the gain, or I'm going to look to do one of these opportunity zone investments. Well, if you pay the tax when you get the gain, you're going to pay $200,000 since the capital gains tax is at 20% right now. You're going to walk with 800 grand in cash at that point from the gain alone. Let's say you decide to invest it. Regardless of even doing that kind of reduction in gain in the future, at the time of the investment, if you invest the full equity and then you finance it. Oftentimes commercial financed buildings or investment-created property can get a 70% leverage from banks. We talked about the distribution, that funded distribution. You can take 700 grand, likely gets funded back. If you take that with the 200 grand that you would have had to pay in taxes anyways, you're really only out an extra hundred thousand dollars, and you have a million dollar investment into a piece of property right now. Then you can benefit from that tax reduction because of holding it for five or seven years. Then ultimately when you sell it, you could potentially walk away tax free on any gain from that opportunity zone investment.
Adam Hooper - That exclusion of the gain, the appreciation, is just, I don't know that most people we talked to really get how big that is.
Troy Merkel - It's huge.
Adam Hooper - It's huge. As it's written, if you take that million dollars, you invest in a property. We're here in Portland. A lot of Portland and kind of near in the East Side is an opportunity zone. Buy a building, do a rehab, and in 12 years, or 10 years, if that's worth $3 million, the $2 million gain there, I pay zero tax on.
Troy Merkel - Right. It's huge. I actually was talking to a real estate developer that he had a plot of land in Denver to do some townhouses, and found out that it was in an opportunity zone. He was evaluating transitioning those so he can build a hundred apartments on there. I was talking to him about the timelines of getting it in and making sure you get the capital gains forgiveness. He goes, that's great and I'd love to do that, but he's like, if I can get it in in time and qualify for this opportunity zone and not have to pay tax on the sale, that's worth it alone. That's how much of an incentive it is. Oftentimes, if you're doing these types of value-add real estate, you're playing for a big jump in value, quite often. Not many people want to take the risk of doing construction. When you take that risk of doing construction, players are making sure that they're going to get a big return on the end. Yeah, it can be quite significant. That's another thing that the guidance helps with and put people at ease, investors at ease, because the original tax reform is expected to expire in 2028. We're not going to go into the political sides. If you think we put people to sleep when we start talking about 90% thresholds on assets, we'll put them to sleep when we start talking about how Congress needs supermajorities for things, but anyways. The fear was what if I hold my asset past 2028, and this concept of an opportunity zone goes away? Well, the IRS came in and said that the concept of an opportunity zone and the ability to take that, it's really a
Troy Merkel - step up in basis, but let's say the forgiveness of any tax owed on the liquidation event of the investment, goes through 2047. That gives investors quite a long horizon there to dispose of these assets, even if the opportunity zones don't outlive the tax reform. Which I actually, if I were a betting man, I'd have suspicions that opportunity zones, or the concept of opportunity zones, maybe with some slight modifications, may very well outlive this tax reform because they did have bipartisan support going into it. It wasn't originally part of the administration's tax bill. It was actually being conceived prior to that. It really has bipartisan support on either side. There's a lot of support for this as a way to promote economic growth, and it's very beneficial to investors. There's a good chance that this could be part of our future for quite some time.
Adam Hooper - That is one of the risks that people are looking at this, of what happens politically in the regulatory environment. Is this something that can be rolled back? This is great, under the assumption that the capital gains rate doesn't go to, like, 50% by the time I come to sell this thing. How are we looking at some of the risks of investing in these things? Obviously if capital gains in 2026 is some astronomical rate, then that's probably less great, but what are some of the risks that investors would be looking at that might differ from risks they would normal see with real estate projects, and how can they kind of mitigate or at least understand some of those challenges when it comes to opportunity funds?
Troy Merkel - Well, actually, I think about that backwards. If the rate goes up on capital gains, it would be even better if it doesn't get taxed at all. We'll see how that continues. One of the things that you have to keep in mind is the cost of capital, the cost value of capital. Again, going back to, your original statement, your original thesis, is that with any good investment, you need to make sure that the investment makes sense and that the return on equity is going to be worth it, even before you consider any of the tax benefits. That's one of the risks is that you are tying up your equity. While there are mechanics and we talked about you potentially getting cash out, you are going to be tying up your equity. Another is that this concept of 2026 can be a very real event where you as a investor may have a taxable event because you're going to be taxed on that original gain, be it even at the 85% of that, and there may not be funds from the investment, or cashflow from the investment, to pay those gains. It might be invested or tied up in the investment. Depending on how successful the investment is, it might not have cashflow or operating funds, or it might not be able to refinance in a way that can give you cash. It's really important that you plan and also have a coordinated plan, with the fund if you're going to utilize an investment advisor, to have a way to pay that gain. That is coming in 2026. That's a unique scenario for a lot of investors. Oftentimes, gains go along with cash. It makes sense.
Troy Merkel - The IRS wants to tax you when you have the cash in your wallet to pay them. But this is going to be an event that wouldn't have that. That's another risk that we're advising our clients against. Then, again, I can't echo it enough, is make sure the investment makes sense. Don't wait or bank on the tax benefits to make this investment make sense. There's going to be a lot of snake oil salesmen out there now. I've seen several people that have all the sudden said, identified they had this tract of land or these worn-out buildings that they've been sitting on for quite some time, they got designated opportunity zones. All the sudden, they've jumped value 10, 20, 30, 40, 50% because they're just trying to capitalize on eager investors looking to defer the gain. Be cautious of what you're getting into. Make sure you do your typical due diligence of any investment. Don't just jump in willy-nilly because you're so excited about deferring the gain. Make sure the investment makes sense.
Adam Hooper - I guess with my example, when 2026 comes, if we're in an environment where the capital gains rate is higher than 20%, than it is today, you're paying the capital gains. You're paying tax at the end of 2026 at whatever the then current rate is, right?
Troy Merkel - Correct, yes. No, sorry, I misunderstood you. Yes, you are correct. That is a risk that could be held. Based of off how the election cycle went and everything like that, it would be hard to pass any sort of significant changes to the capital tax rate, but it is a risk. It is a risk that investors have to consider.
Adam Hooper - Why would somebody do this? Or why would they not do this?
Troy Merkel - Why would you do it is if you have significant capital gains and you're looking to be a long-term investor in some real estate, an opportunity zone investment's the way to go. The benefits that you're going to get from, forget the reduction. You have a deferral of paying taxes. I don't know about you, but I like to pay my taxes as late as possible. If I can push that. I have to pay them to keep my CPA license, so I pay my taxes, I want that to be known, but if you can defer your taxes six, seven years, well, that's some value. You get the reduction of the gain. Then, also, you can walk way potentially tax free on any proceeds if you hold it long enough from the sale event. That's significant. It can be a tax planning strategy. You don't necessarily have to invest all your gain or all the proceeds. You sold your family business. Not all of it needs to go into an opportunity zone to benefit from it. You only have to do the gain. If you can walk away with a substantial enough proceeds that you can invest in more liquid assets, you can put it back in the market, put it in mutual funds, whatever other types of investments you're doing based off your individual investment strategy, you can defer tax to that tax plan, lock up some of the cash, but still have the ability to utilize that other cash and keep it liquid. The reason you don't do it. If you don't have capital gains, it's, unfortunately, not available to you. Also, if you don't identify an opportunity that makes sense structurally. Don't chase or throw away money into a bad investment. You are still making an investment,
Troy Merkel - and there's always an investment risk there. You can still lose money in any investment. Any real estate deal can lose money. If you don't find a deal that fits your correct investment profile, you don't make the investment. Don't ever just make the investment because you want to defer taxes or whatever it is 'cause there's been plenty of real estate deals that have gone sideways because people didn't quite understand the investment they're getting into.
Adam Hooper - That pretty well sums it up. What's next? What are we expecting to hear from Treasury? What's coming up? Is there anything, any timelines, anything that we need to be looking out for? Anything investors need to be keeping their eyes and ears open for?
Troy Merkel - There's expected to be further clarification. The regulators have said it's coming by the end of the year. Again, based off of how long it took for the regs to come out in October that were supposed to come out closer to Labor Day, I would expect it to be closer to January or February. Although they have acknowledged, we have connections with people inside the IRS and other regulators, and they've acknowledged that due to the time sensitivity of the opportunity zones, it's getting preferential treatment when being evaluated, so we're hopeful that it'll come out. The biggest piece that we're looking for is making sure all businesses qualify, although it looks like it will. There's really no restriction on the real estate investment. That's really if you get into some sort of other types of business investment. Real estate investors are moving full tilt. The one question that I do know the real estate investors want, actually there's two questions that we want to get clarified. One is that we talked about that recycling of capital. What is the time horizon? How long do I have? If I have a sale event within the fund, how long do I have before I have to reinvest that gain? We'd like some clarification on that. The other one is can I take the cash and invest it if I'm going to be getting a gain later in that same tax year? The IRS has acknowledged that they have to address that. You may have cash proceeds now. You want to get in on a deal. It does say that it needs to be a new business subsequent to 12-31-2017.
Troy Merkel - It has to be after the Tax Reform Act came into play. But there's some ambiguity about whether or not you have to have had the gain, or if there's a timing difference. Say you have the cash in March to make the investment, and you know a gain is coming in July or later, can you still make that investment? Can you still take advantage of that? Those are really two of the ones that we're getting questions on. Unfortunately, as of right now, we have to tell them we have to wait and see. But we hope to get some clarification on that later this year.
Adam Hooper - With that second piece, what you're saying is if there's a property that's for sale in February, and I got to close in March, and I don't have a gain that would trigger my ability to invest that gain until October or November, almost like a reverse exchange. Can I acquire this thing in February or March, and then earmark the gain that I attribute to that in October? That's what has not been clarified.
Troy Merkel - Exactly, exactly.
Adam Hooper - Whether it's a full tax year thing or whether it's a sequential gain recognition and then deployment.
Troy Merkel - Yep, exactly.
Adam Hooper - Okay. I guess final question, since we brought up the exchange thing again, is this an augment to or a replacement of the 1031 exchange model for real estate investors?
Troy Merkel - It's an alternative to. There may be some situations where a 1031 exchange still makes sense. You can defer that gain, effectively, indefinitely. But I see the opportunity zones being something that investors are really going to have to weigh in. It's going to take a lot for a 1031 to necessarily make sense, compared to an opportunity zone investment, just because the regs are so much more favorable to the investor. I like flexibility in my investments. I think no matter how you come down on either, it would be hard to argue that you don't have more flexibility with an opportunity zone investment than you would with a 1031.
Adam Hooper - Okay, there we go. That's a pretty good summary, Troy.
Troy Merkel - Great.
Adam Hooper - We'll put links in the show notes to all the things that we discussed. If people want to learn more about what you're up to or what RSM is up to in the space, how would they do that?
Troy Merkel - Like everybody else, go to our website, www.rsmus.com. If an opportunity zone article with my face isn't showing up on the homepage, you can just type it in and search opportunity zones. We have articles coming out every few days, but happy to address any other questions that investors have if we haven't addressed them in articles there.
Adam Hooper - Great. As always, if you have questions on this, again, we know it's a fairly complex subject, so if you have questions, you want any clarification, send us a note to firstname.lastname@example.org, and we'll either get them along to Troy or see what we can do ourselves. Thanks, again, for listening to another really informative episode. Thanks for coming on, Troy.
Troy Merkel - Thanks for having me, Adam.
Adam Hooper - All right, thanks, everybody. With that, we'll catch you on the next one.
Tyler Stewart - Hey, listeners. If you enjoyed this episode, be sure to enroll in our free six-week course on the fundamentals of commercial real estate investing. Head to realcrowduniversity.com to enroll for free today. In RealCrowd University, real estate experts will teach you the important fundamentals, like the start with risk approach, how to evaluate real estate sponsors, what to look for in the legal documents and much more. Head to realcrowduniversity.com to enroll for free today. Hope to see you there.
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