Derek Uldricks of Virtua Partners joined us on the podcast to discuss the tax benefits of Opportunity Zones.
An Opportunity Zone is an economically-distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment - IRS.
Opportunity Zones were created as part of the Tax Cuts and Jobs Act on December 22, 2017.
At the time, the tax benefits of Opportunity Zones were a little discussed provision. Now, with the Treasury Department and the Internal Revenue Service set to provide further details on Opportunity Zones over the next few months, this little discussed provision is starting to make its way into the mainstream.
While we are still waiting final details, Derek joined us on the podcast to discuss what is currently known about the tax benefits of Opportunity Zones.
- Internal Revenue Service: Opportunity Zones Frequently Asked Questions
- Policy Map: Opportunity Zones Map
- Derek in The Wall Street Journal: New Hotel or Affordable Housing? Race Is On to Define ‘Opportunity Zones’
- Derek in Bloomberg: Bloomberg Markets: Uldricks on Opportunity Zones (Audio))
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 - Tyler, I am well. Doing really well.
Tyler Stewart - Oh yeah? I saw you look out the window. Why are you doing so well?
Adam Hooper - Well, I was just checking because it seems like we've had a pretty good streak of weather here in Portland.
Tyler Stewart - It's nice, not as nice as where our guest today joined us from, though.
Adam Hooper - Oh yeah? Where is he from?
Tyler Stewart - He was down in San Diego.
Adam Hooper - Oh, I love San Diego. Who do we have on today, Tyler?
Tyler Stewart - We had Derek Uldricks, President of Virtua Capital Management.
Adam Hooper - Yeah, and I guess a little pre-episode apology here, we get a little bit dense on some tax issues today. But lot of really good information, talking about 1031 exchanges, what the recent tax act did for 1031 exchanges, and...
Tyler Stewart - Opportunity zones.
Adam Hooper - Opportunity zones, which, there's not a ton of information out there. This could be as big for real estate in tax advantaged treatments as any 1031 exchange that's been out there. There's three really huge components of it. There's a deferral of recognition of that capital gains, there's a step up in the basis, there's also an exclusion of any gains for the asset that you invested in these opportunity zones. So you get the triple threat there. It was great to have Derek on today. They're very involved in this space. They're one of the first movers in the opportunity fund, opportunity zone world. So a lot of really good information in there and should be very, very, again, dense episode for listeners out there about what an opportunity zone is.
Tyler Stewart - Absolutely, and a little asterisk. We recorded this before everything was finalized with opportunity zones. So take that in consideration.
Adam Hooper - Yep, so by the time this episode airs, we should have the final guidance from the Treasury. So there might be some changes, minor changes to some of the stuff that we talked about on this episode. But we'll be sure to follow that up in the show notes and make sure that any clarifications that need to be in there are in there. Think that's enough of us talking. As always, we appreciate comments, ratings, feedback, every time you write a comment or view on iTunes, gets us out in front of more people. So we appreciate that. If you have any questions, comments, feedback, please do send us an email to email@example.com. Think with that, let's get to it.
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Adam Hooper - Well, Derek, thank you for joining us today from what I believe to be a hot and sunny Arizona climb. Is that right?
Derek Uldricks - I'm actually back to San Diego today. So I escaped the heat finally.
Adam Hooper - But you guys are, you're making a move out that way, right, starting an office out in Arizona?
Derek Uldricks - That's correct, yes. We just closed on our new headquarters in North Scottsdale. So really excited with that, nice Class A building. And then I will be relocating to the desert. So good in that's a lot cheaper. Cost of living and taxes are much better than California, which, that's going to go a long way. And yeah, looking forward to it. Actually love getting out there and hiking and the desert in the wintertime. And the colder seasons are really nice place to be. Summer is brutal, but the other times are phenomenal.
Adam Hooper - Yeah, well, maybe keep your ties to San Diego so you can sneak away there in the summertime, avoid the heat.
Derek Uldricks - Exactly, exactly.
Adam Hooper - Good, well, we've got a very interesting conversation today. We'll talk about 1031 exchanges, how most people in the real estate space have looked at tax deferral strategies, and then we'll talk about opportunity zones and opportunity funds, which was part of the most recent Tax Act. But before we get into that, why don't you take us a little bit through your background, how you got into real estate, what you guys do now at Virtua, and maybe a little bit of what got you to where you are in the real estate business today?
Derek Uldricks - Yeah, absolutely. Thanks, Adam, of course. This is Derek Uldricks, President of Virtua Capital Management. I began my career in finance about 15 years ago in the mortgage banking industry. I then shifted into commercial real estate restructuring during the downturn, so I got to see a lot of special situation real estate as well as several turnaround projects on distressed assets. So I've an interesting perspective when it comes to commercial real estate since I've seen some pretty challenging situations. I also spent a big part of my career consulting with various 1031 investors during the downturn, 1031 exchange investors, providing them insights into certain tax situations, helping them decide which way to go on loan restructuring, providing that sort of advisory function for them. I then got an opportunity to oversee all of the fundraising and fund management for Virtua Partners. So I currently now oversee all of our fund management duties, product development, investor relations, and fundraising functions for the company. Virtua Partners, of course, private equity real estate firm. We have offices now in Scottsdale as well as California and Hong Kong. So we do all things commercial real estate. We are focused primarily in the past on restructuring troubled assets. We've done about five billion during the downturn. We're now focused in on hospitality real estate development as well as structured finance. Three things that we focus on, of course, we also do investment management and fund management,
Derek Uldricks - and, I think, now we have 11 total funds under management. And we're continuing to grow, as you alluded to. The opportunity zones as a part of the new tax reform, really exciting place. We're forming new partnerships and funds around that strategy and around this new program. And future looks bright for us, continuing to grow. We have now, I think, 35 full-time employees, full-time investment professionals, and focused in on, of course, doing right by the investors and all things investor relations is what I focus on.
Adam Hooper - Good. And is the Hong Kong office, is that primarily for sourcing investors? Or do you guys actually have any real estate activity out there?
Derek Uldricks - We focus our real estate investing in the US. We have our research group based in Hong Kong, and then we also have some some capital raising functions out there. So the PRC, Hong Kong, Singapore, are great places to raise capital. That has somewhat slowed down a bit since some of the monetary restrictions from the PRC. So we continue to be there. We still have an office there and have a presence there. It's a great place to raise capital. What we tend to see is those investors come back into the market, come back into the US market, when the US market is down. We also want to, of course, have a diversity of investors so that we can tap those investor bases depending on, rather not depending on where we're at in the cycle. We can irregardless raise capital from investors outside of the US. And that's an important place for us.
Adam Hooper - Yeah, and then touching on, since you brought up cycle, not us, where, I think there is some concern out there, right, of how far into the cycle are we? This has been a pretty solid recovery. I'd be curious to kind of get your thoughts on where we're at, either within your specific product focus or geography. It's, like, what's your overall take on where we're at in the market? Still got some legs? We kind of nearing peak, or where are we?
Derek Uldricks - It's really hard to tell, right? I mean, you hear a lot of people talking about, of course, interest rates, certain headwind into the markets, and people, economists and conventional wisdom, making predictions about when the next recession will occur. Generally, from Virtua's perspective, we're confident with where we're at. But of course we're always looking at potential headwinds, trying to read tea leaves. When you look at the consumer, they seem to be doing pretty well. When you look at some of the reports on consumer sentiment very high, the same, in our opinion, goes for business. With the tax reform, we believe you're going to start to see the real impact next year, when consumers have more money in their pockets. We're thinking that that capital should bounce around the economy and also help, of course, GDP grow. On the real estate side, we are concerned with interest rates and the flattening of the yield curve. This typically suggests a slowdown in the future and is a bellwether for recession. But of course it's just extremely difficult to tell exactly when that will occur. We are now in the second-longest expansion on record. So some are beginning to worry that we're a bit long in the tooth. What we have seen in our research, and this is, of course, well-documented, is the most common cause of a recession is a hawkish effect. So we're really watching that closely. That's something that we're monitoring on a daily basis. These factors all combine and weigh in, of course, on our investment basis. And we do continually shift our strategy
Derek Uldricks - to both certain asset classes and geography, depending on how things change. On the asset side, we're now shifting our strategy more into assets that have performed historically well in downturns, like residential real estate as well as well-positioned limited service hospitality. So on the residential side, multifamily did pretty well during the downturn. It did have a couple of down years. We also really like residential real estate as a for-rent product. If you look at the history and you look at how that asset class performed during the downturn, it actually never had a down year. Believe it or not. We did the research, we were astonished when we saw that. That's actually had a flat or done better every year. It's never had a down year, even through the downturn, which is crazy to us. But it's true. And we also like well-positioned limited service hospitalities. So Marriott, Hilton-branded hotels, the limited service hospitality tend to have higher margins, they're better businesses to run more simple, and they tend to perform better in a downturn. What we typically like to do is invest in assets that have some sort of recession-proof economic driver nearby. So we have a couple projects right now, hospitality projects, that are near hospitals. So of course whether there's a recession or not, people still have to go to the hospital. They still have to get taken care of. We have a deal in Houston right now, next to the Houston Medical Center, one of the largest medical centers in the world. People still have to get fixed, right?
Derek Uldricks - They still have to get their cancer treated, they still have to go get their whatever done when there's recession. So we think that's a good place to invest during the downturn. We're also beginning to reconsider how we leverage assets. We tend to take a more conservative approach now. When we're doing deals, we want to have more cushion in case we do have some sort of correction. The nice thing, of course, with being in residential real estate as well as hospitality, in theory you're never going to have 0% occupancy rates. If you own an office building and you get hit and you get stuck in the downturn, you can go to 0%, right? But if you're owning assets that are in 95% occupied markets, yes, during a downturn you may have a dip in occupancy or rate, but you're probably not going to go to zero unless you have a terrible asset that doesn't compete with the competition. So we are keeping that in mind. We're very much risk averse. Because of our experience during the downturn in restructuring some of these underwater, deeply troubled assets, we're just seeing how bad it can get for some of these investors. And so we're always sort of fighting the last war, right, and thinking about that and not wanting to get put in that position again as we structure our investments with that in mind.
Adam Hooper - Yeah, I guess I'd be interested how has that time on the workout side informed or, I guess, kind of shaped how you guys approach underwriting at Virtua. 'Cause that was a huge, hopefully once-a-generation kind of event. But those that were in the position to learn from it and kind of roll their sleeves up, we talked with Justin Palmer at Synapse. That was how he got his start, cut his teeth with Lehman workouts. And I think there's a lot of really good lessons that were learned if you were there to take advantage of those learnings. So how has that kind of informed your strategies or your look at underwriting now at Virtua?
Derek Uldricks - It's a big part of it. We did a lot of office restructuring during the downturn. So we did see some assets go to 0% occupancy. And it was a disaster for those investors. So we don't do that type deal. If we're going to do office assets, we typically have some sort of credit tenant on a long-term lease and we have to feel very strongly that the tenant is going to stay in the building for a long time otherwise, we're not going to do the deal. Obviously we put in our own money as well. On the underwriting side, I think it really comes down to being conservative on the, of course the exit assumptions and the rent growth. I mean, anytime you look at a pro forma, there's no such thing as a pro forma that shows an investor losing money, right? They all look good. So we take that experience and we do implement that moving forward. There's nothing specific across the board that we implement. For us it's just about detailed market research. We have to feel really comfortable with the market, there has to be strong demographic reasons to be in the market. We typically invest in low tax states. We're staying out of California for the most part. A lot of people are leaving California for some of the same reasons I'm leaving. So we tend to stay out of those markets that have those long-term headwinds. That's a problem that we saw in the last downturn. Suburban office tends to be problematic in a downturn as well. So for the most part we stay away from that, unless it's a compelling deal in a market that we really like. We'll go into there, or we'll go into that deal.
Derek Uldricks - But again, back to the way the strategy has shifted now, it's all about residential real estate, multifamily, single family, for rent, as well as hospitality. We're also, of course, looking to minimize risk on our development transactions as much as possible. So we do a lot of vertical development as well as horizontal development. Entitlement risk is one of those big unknowns for investors. So when we're underwriting assets, we're saying, "Okay, we're not going to do this deal unless we have a 90% probability of completing these entitlements that we've underwritten the project to perform at." And so those types of things we implement into our underwriting moving forward.
Adam Hooper - Very good. Let's get a little bit of a shift of gears here into also again, I think you said you had some experience in the 1031s, more from the consultancy side. A lot of the deals that we do on RealCrowd aren't necessarily able to take advantage of 1031 exchanges. Units in an LLC typically aren't able to take advantage of exchanges. But for listeners out there that have their own ownership or properties they might own in total, we've done a couple episodes, but maybe just a quick walk-through of 1031s, and then we'll get into the opportunity zone. So from a basic standpoint, what was your experience in 1031 world? How has that maybe changed? I know there's been some, not necessarily shakeout, but there's a lot of 1031 activity running up to this last market cycle. Have you seen a lot of 1031 activity in this current cycle like we did in the last one?
Derek Uldricks - Yeah, we have. For the most part, the 1031 activity, well, 1031s have been around for a long time. It's a tried-and-true investment strategy for investors in real estate. During the last run-up, you saw a lot of investors that were once actively managing property, so investment properties that they owned, maybe they had a duplex in Santa Monica and they essentially came to the point where they didn't want to fix the toilets anymore and deal with the tenants. They were looking to exit those actively managed investment properties and move into more passive, professionally managed investment opportunities. So there were some investment vehicles that were created back in the run-up to the downturn that allowed investors to invest passively into buildings and multifamily complexes, essentially pooling their investments with other investors.
Adam Hooper - And that was a...
Derek Uldricks - In order to take down...
Adam Hooper - Tenants in common, right? The TIC industry is what you're referring to there?
Derek Uldricks - Correct. Yes, the TIC industry was huge. There was a lot of business that was done back then. Those assets had a lot of problems, a lot of problems with fees. Everybody was making money except for the investors, right?
Adam Hooper - Yeah, that's true.
Derek Uldricks - Those managing the real estate were making money, the people who were lining them up on the security side were making huge commissions, and so everybody thought the investors did pretty well. As that market deteriorated in 2008, 2009, those investments became challenged, let's just say that. So a lot of them were underwater. Most of those projects were financed with commercial mortgage-backed security financing or CMBS financing. So when these investors had problems with their properties, they had no one to negotiate with because the lender was essentially an agent of a large pool of mortgages, right? So it's not like they can negotiate directly with the lender they'd been with for 20 years. It was just some random company that was managing the pool of the loan. So they had a lot of problems with renegotiating loans, loans were maturing, properties were underwater, people were getting foreclosed on, it was a complete mess. And so we did a lot of cleanup in that space. Fast forward to today, that industry has morphed into a new kettle of fish, what's call the Delaware Statutory Trust or DST. So it's similar in that the investors can pool their investments into a 1031 exchange out of a property, their duplex, their home, whatever it is, into a DST, a Delaware Statutory Trust, and they can buy a larger property, have someone else manage it, and they just get a coupon every month. They just get cashflow off of the investment. Now, that is one type of product that's out there. That's more geared, I would say, to a probably an older demographic.
Derek Uldricks - Those investments tend to be much more conservative on the financing side as well as the current cashflow side. The best you can do in that market is really get a 6% current pay. These investors are more into it for the tax deferral. They want to defer the taxes until they pass away. So they get a step up in basis and they can pass that asset off to their heirs, to their children or whomever, potentially tax free. That's the whole gain. What you now see in the other parts of the market, what you're now seeing is, investors have investment properties and they're exchanging into different markets so they'll stay, for example, we have an asset in San Francisco entirely appreciated. You've held on to it for five years, you sell it, and then you're looking to invest in another market or invest in a better deal that gives you better cashflow. That's what we're seeing with the 1031 exchange these days. There's no real organized market outside of the DST marketplace that I touched on for investors to go. What investors have to do if they're interested in selling the property they have and deferring taxes, and by doing a 1031 exchange, then they have to go out and find a replacement deal. You have to go out and do the research, find a replacement property, put together the financing, jump through all the hoops, and the restrictions associated with a 1031 exchange, and then complete the transaction. So it's much more of a fragmented market. It is somewhat organized in that there's, of course, a lot of proxies, right? I mean, you can sell your home and buy another home down the street
Derek Uldricks - or whatever you want to do. There's a lot of places to go. But it can be a difficult transaction to complete, especially if you're going after the same deals with all the other 1031 investors. There's a lot of people in the market chasing the same deals. That tends to bid up the price.
Tyler Stewart - Can you dive a bit into the restrictions with a 1031, the timing restrictions and the like kind restrictions?
Derek Uldricks - Sure. Probably the biggest complaint that we hear from investors on a 1031 exchange is the timing constraints. When you sell a property, you essentially have 45 days from that initial sale point in order to identify a replacement property. You only have 45 days. In addition to that, you have just 180 days in order to complete the exchange, meaning from the day you sell, you have to complete a new acquisition by the 180-day mark. So it's pretty tight timeline. In addition to that, part of the regulations require that the investor must use what's called a qualified intermediary in order to complete the transaction. So a qualified intermediary or QI is similar to an escrow account, right, where they receive proceeds from the sale of the property, they hold it for you, and you basically instruct them where to place the money. So it adds a bit of an element to the process. You have to coordinate that, get the investment proceeds to go into the qualified intermediary, work with the qualified intermediary to identify the property, and then you instruct them to distribute the proceeds once you have the asset lined up. It's really important to stay within that 180-day period, because if you don't do it within that timeframe, you blow your exchange. So you therefore lose the tax deferral and it's gone, it's completely gone. So whatever taxes you had been deferring to that point in time, if you don't make it within that window, then you're out of luck. There's nothing you can do, you've blown your exchange and you have to pay the taxes.
Derek Uldricks - So that's a big part of this whole consideration factor for investors, right, is, am I going to be able to complete this exchange within this time period? The other big problem, of course, is finding the replacement property. So you have to go out and find something that you're willing to invest in, right? And that can be very problematic. You also have to consider the debts that you have from the property that you're selling. So there's something called boot, which occurs when you receive cash or when you have a mismatch in the amount of debt on your relinquished property versus the one that you're buying. So in other words, you have to replace the same amount of debt you have on the property that you're selling. Say for example you have an asset that's worth $2 million, and you sell it. And you have $1 million of debt on that asset. You can't go out and buy a $1 million property. You have to buy a property that's worth $2 million or more and you have to replace the debt with new debt. So not only do you have to go out and find a replacement property, but you have to go out and originate the financing. So you have to work with a lender to go get that done. So it adds a bit of risk to the equation. So when an investor's considering doing a 1031 exchange, especially for the first time, those who have been through it a few times know the routine, you have to consider that, right, the time period as well as the steps involved in order to complete the transaction. And this, of course, is a well-established rule. So the rules are very,
Derek Uldricks - they're very much known to everybody. So they're very easy to find and this has been done quite a bit over the years, obviously. And so for us, when we're looking at a 1031 exchange, the other downside is, you have to invest all the proceeds. So going back to the concept of boot, you can't pull any cash out. So you have to reinvest all the proceeds into this new asset. So what we saw in the downturn, and this is a big problem, is that investors ended up accumulating a lot of wealth in one asset. But because they were doing a 1031 exchange, they had to keep reinvesting those proceeds into one or two assets. And so when you do that, you have an overallocation into just one or two projects, right? So, Investing 101, you want to be diverse. You don't want to have all your money in one particular asset. So that's one of the downsides of a 1031, 'cause you have all that money stuck in potentially just one or two or three assets, which can be very problematic, especially in a downturn, right? So that's just something to think about when you're considering a 1031 exchange.
Adam Hooper - Well, then, on the boot, just to clarify, you can take capital out, but that then is subject to the tax, right? You can pull it out...
Derek Uldricks - Correct.
Adam Hooper - But you have to pay tax on that. I think that's one of the things, the reason that the TIC industry and now the DST industry has existed, is because it does simplify, from a convenience perspective if nothing else, the ability to do a 1031 exchange and not have to go through all those challenges you just mentioned. Now, not to say that they're not without their own challenges, right? I think the TIC industry had some very, just kind of fundamental structural flaws in terms of control, and if you have someone that, if the TIC is capitalized by people that are putting all their assets into this, they don't have additional capital to cure any problems or challenges at the asset level. Similar with the DST, right, you're very restricted in what you can do to improve the property at the asset level. So there's, for that convenience, you trade off some of those other challenges, right? I think that's just something to look into for investors that are out there. Make sure you understand structurally what you're investing in with some of these other products out there, outside of just traditional kind of real estate ownership.
Derek Uldricks - That's correct, yes, I agree with that.
Adam Hooper - Okay, so 1031s, fairly known quantity. With this latest tax bill, there are restrictions, or I guess, further clarification on the definition of like kind, now very clearly defined as just real estate for real estate. Could be, like you said, a duplex for an office building or a vacation, a rental home for a multifamily place. So as long as it's real estate, that qualifies for like kind. With the new tax bill, there is a creation of qualified opportunity zones and qualified opportunity funds. I know that's an area that you guys have spent a ton of time on. You were just recently quoted in the Wall Street Journal. Very, very, very interesting part of this tax bill that I don't know how many people have really paid attention to yet, but could be as big, if not bigger, of an impact on our industry as what we saw in 1031. So let's start peeling into that. High level, what is a qualified opportunity zone?
Derek Uldricks - Sure. Opportunity zones are geographic designations that were established under the Trump Administration tax package. So investments in these areas allow for investors to defer as well as reduce capital gains on current investments that are reinvested into these areas. The program also allows for the elimination or reduction of capital gains taxes on appreciation of opportunity zones if held for a certain period of time. So these opportunity zones are essentially areas that were designated by the governors of each state and approved by the Treasury. When investors funnel capital into these opportunity zone investments, there are certain and really good tax benefits that go along with investing in these opportunity zones.
Adam Hooper - And this is beyond just real estate, right? 1031 exchange only real estate for real estate. With opportunity zones, it's any capital base that's subject to capital gains treatment, correct?
Derek Uldricks - That's correct. Differing from a 1031 in that an investor can take any capital gain. So you sell stock, you sell bonds, you sell art work, you sell your dog and you make a million dollars. You can defer those capital gains that you make on that asset and invest it into an opportunity zone investment. So there's no limitation on the amount or the type of gain. It can be short-term, it can be long-term, there's no limitation at all. You can defer those, defer the taxes you pay on those gains by investing in an opportunity fund and also get those other benefits that we talked about, or that we're going to talk about.
Adam Hooper - I think it's important before we get too deep into this, we'll caveat this whole conversation that we're recording here in the latter part of July, so there's still some final rulemaking from the Treasury that needs to be put in place in terms of some of these actual specifics, but I think, broad strokes that we'll cover today is from kind of best understanding as of end of July, before any further clarification or formal guidance from Treasury and IRS, all that good stuff. We'll make sure we get that disclaimer in here. So you mentioned the three tax advantages of this are a step up, first the deferral. So you don't have to immediately recognize that gain today. The step up in basis, and then potential exclusion from appreciation for the assets that you invest in. Let's talk about the deferral first. I own million dollars of Apple stock. I've got a $750,000 gain. I sell my million dollars of Apple stock, I invest that in a qualified opportunity zone. What do I do from there? What does that mean from the tax standpoint on that recognition of gain?
Derek Uldricks - Sure. Let's say for example you're in a 20% tax bracket, just for ease. You're going to pay 20% on your capital gains. So that 750,000.
Adam Hooper - Let's call it a million, just for ease of numbers. So million dollars gain, 20% tax bracket. Make it easy for you.
Derek Uldricks - Perfect. I like easy, I like easy. So, okay. So million, and you're paying your 20% taxes, although it will be higher than that, but let's just use 20. If you just said, "I'm going to cash out and not think about an opportunity zone investment." of course you're going to owe $200,000 in capital gains tax. So the first benefit is, of course, the tax deferral of the $200,000 that you would have already, or would have paid if you did not invest in one of these opportunity zone assets. So that, of course, is a tax deferral until December 31st, 2026. So it's a significant period of time of which you can defer those taxes. The way that I look at it is, it's essentially a free loan from the government, right? Under normal circumstances, cashing out of an investment, you would take that $200,000 and give it to the federal government. Instead, they're letting you keep it. On it, that's 0% interest. So you can use that, use those funds, essentially to invest in one of these opportunity zone projects for 10 years. So you don't have to pay that $200,000 until April 31st, 2027. So can basically a 10-year tax deferral on that $200,000. So the way I think of it is, it's essentially a free loan from the government. They're just allowing you to use what is their money to invest in these opportunity zone projects. If you hold on to your investment in an opportunity zone project or fund or investment for five years, you get a 10% step up in your basis, in your tax basis. So effectively, the $200,000 that you are deferring, you get a 10% step up in that. So your tax bill goes down by $20,000.
Derek Uldricks - Now you're deferring the 200,000, but you get a 10% step up, now you only owe 180,000. If you hold it for an additional two years, you get an additional 5% step up in that basis. So now it went from 200,000 originally to 180,000 after five years, now it goes to 170,000 after the seven-year mark. It gets better. The most important part of this whole program is the third and final piece, which is the tax elimination. If you hold on to an investment for 10 years in an opportunity fund, all of the appreciation above and beyond the $1 million that you invested into this opportunity zone investment, right, all of that gain, let's say that one million turned into three million, that $2 million in lift that you achieved through investing in this opportunity fund, you pay zero tax on that. There is no capital gains tax that the investor has to pay on all of that gain, all of that $2 million in this particular example. So it's an amazing tax benefit for investors, right? I mean, it's just, it's great. So for those who have been around long enough to know what happened in 1986 and 1987 and the tax reform, how all the goodies were taken away from real estate, this is like the opposite of what happened with that. I mean, all these great things got put back in. What's also really interesting about this.
Tyler Stewart - I was going to say, on the third part. Yeah, go ahead.
Derek Uldricks - I was going to say just one quit point. Not only do you get the tax benefits of the opportunity zone, right, so you get the tax deferral, the step up in basis, and the tax elimination on gains, you also still get to do all of the depreciation, all of those other expensing, that are still available to real estate investors. So it's like the best of both worlds. No taxes you have to pay on any gains, all the deferral, all the step up, and you still get to take depreciation to offset income in the rest of your portfolio. You can take those passive losses, all these offset some of that income, and shield income in other parts of your portfolio. So it's an amazing tax benefit for investors and it hasn't really been widely reported on yet. So I'm glad we're doing this and having the chance to talk to investors about it. And of course we're very excited about what it's looking like so far.
Adam Hooper - So I was going to say a couple things. The exclusion of that capital gains tax is, I mean, that is such a big deal. 'Cause even in a 1031 exchange, that's just a perpetual deferral until, again, the ultimate exit, which would be death and then passing that on to your heirs and get that step up in basis. But the exclusion, that's not a perpetual deferral thing, right? If you have that two million of gain that you described in your scenario there, you sell that asset, you get that two million and, I mean, you're taking that out tax free, right? There's no trailer that you have to do something additional with that to get those benefits, which is just, that's a huge, huge deal.
Derek Uldricks - Correct. I mean, the downside to the 1031 is that you have to die to get the step up, right?
Adam Hooper - The ultimate exit.
Derek Uldricks - With the opportunity zones, yeah, exactly. With the opportunity zones, there's three keywords, or two words, automatic step up. So after the 10 years, it automatically steps up. So you don't have to jump through any hoops, it's an automatic thing that occurs. The other really interesting part is that, when you look at the tax, or look at the legislation, you look at the statute, it says all of the basis steps up. That includes any depreciation that you take. So if you don't have to pay depreciation recapture on an opportunity zone investment, that just further sweetens the pie. So with one of the downsides with the 1031 is if you do decide to exit the 1031 early, you may have to pay, you most likely will have to pay what's called depreciation recapture. And you can't offset that tax bill with other losses in your portfolio unless you have ordinary losses, which are pretty rare for investors. So just another weight that's pulling the investors in favor of the opportunity zone, to get that step up of depreciation, another gift. So we'll gladly take it.
Adam Hooper - And then one other small point, again, in difference from the 1031 is when you invest that gain into these qualified opportunity funds. You can take your original basis out that you originally invested, right? So again in our scenario, I've got $1 million of gain in Apple stock, say I bought it for 200,000, I liquidate it for a million two. I can take my $200,000 initial basis out and then that million dollars goes into this opportunity fund. So it's not an all-or-nothing thing like you'd have the boot in the 1031 exchange. In the opportunity zones, you can actually take your initial basis out and then you're only investing that gain that would be subject to this kind of, again, the triple threat, the deferral, step up, and exclusion.
Derek Uldricks - Exactly. So that's one of the things that we're already talking to investors about, because going back to the problems that we saw in the downturn with investors who were too heavily allocated into one or two assets, they may have had 60% of their net worth stuck in two deals that went upside down in the downturn. If you can pull out principal, you can pull out your basis and rediversify that, it's just the smarter thing to do. I mean, at least in theory. And you want to be much more diverse. You can invest in whatever you want with that principal. You can invest in bonds or stock or whatever you want. There's no limitation on what you can do with that investment. The other great thing is, with an opportunity zone investment you don't necessarily have to invest the total, the full million, in your example, Adam. You can invest 75% of that or 50% of that or all of it. It's really up to the investor. So there's a lot more flexibility with the program.
Adam Hooper - And now, since you're talking about what happened with the exchanges in the downturn, do we have guidance from Treasury yet in terms of what would happen if there were losses within the opportunity zones for some of these gains? How does that get treated, or is that still unclear?
Derek Uldricks - There is some, there is mention of it in the statute. So it's actually good for investors. If you do end up losing the million in this example, say you pick a bad investment, you invest in something that goes upside down, you don't pay taxes on it, 'cause it's gain. You're deferring your gain. So you don't have any tax liability. So if you lose it all, you lose it all, then you don't have to pay the gain that you deferred, that's simply wiped out.
Tyler Stewart - Is there any sense for timing? So if I saw my Apple stock today, is there a window by when I'd have to invest into an opportunity zone?
Derek Uldricks - Yes, there is. It's 180 days, similar to the 1031 exchange in that you have to invest it by that point in time. The main difference here is that you can take custody of the asset. So if you sell and you recognize the gain, it goes into your account, you can invest it, you can actually invest it in anything that you want over the 179 days. So if you said, "January 1 I sell my Apple stock and made a million dollars in capital gains." you can invest that in a short-term investment, 90 days or whatever, get the money back, and then still invest in the opportunity zone by the 180 days. So you can actually be in receipt of the cash, do what you want with it for 179 days, as long as it ends up in the opportunity zone investment by the 180 day mark. So we're getting a ton of calls from investors who sold stuff in February, right, they're on the clock. So they have to make an investment by their drop-dead date, otherwise they lose the opportunity to take advantage of the program.
Adam Hooper - And similar to a 1031, once that 180 day hits, then those gains are, you're done.
Derek Uldricks - Yep.
Adam Hooper - I know there's a lot of operational nuances for fund managers that are out there, right? The 90% test, the timing at which you have to improve the assets, which I don't necessarily need to get into too much of that today, but from an investor's perspective out there, you guys are obviously having a fund in the market that's going to be focusing on these. Do you think this is going to be more of the, what we saw in the 1031 world a lot of early days, was kind of the DIY, "I'm going to go exchange my duplex for this retail strip center or single tenant lease deal." or do you think most of it's going to be because of the complexity more institutionally-managed funds? Or do you think a mix of both? Or too early to tell?
Derek Uldricks - I think it's going to be both. Yeah, I think it really depends on the investor. If you're more of a, if you're someone who has 50 to 100,000 to invest, I think your options are going to be an investment fund like something that we have. That's, of course, professionally managed. And then you're also going to have opportunities to invest in one-off transactions. I think that's likely to happen. The landscape for opportunity funds is being shaped, I think, primarily by one of the regulations that you had alluded to, which is the substantial improvement requirement. The way the law is written is, they want this capital to go to projects that infuse capital into those markets. You have to increase your basis in the investment that you purchased by 100%. You have to buy something, you have to put in additional capital. So that sort of changes the game a little bit in terms of who can play in that space. So the bigger players, like the Blackstones of the world, KKR, the big private equity players, they're not necessarily developers. And they, I think, are going to have a hard time playing in this niche-y of a space. They don't have the deal flow. They don't necessarily have the desire, because they're making a lot of money elsewhere in the places that they're playing. Not to say that that couldn't change. But at least where we're at now, it's, we're really the only game in town. There are some other competitors coming about, but it's really just us. And I think we have a competitive advantage because we have the deal flow.
Derek Uldricks - So we have projects that we've held onto in the pipeline which just ended up being in a opportunity zone that are shovel ready, ready to go, we're ready to move on them, they're going to go right into the fund, and we're going to be able to maintain compliance with some of the regulations, whereas some of our competitors are not. So we're running the race, we have a head start because we have all of these deals, and of course a firm grasp on some of the regulations. So I do think that you're going to see more players into the market, no doubt. Because of some of the regulations, for the most part these investments are going to be vertical developments, so construction. So there are limited number of players that have both expertise on the tax side, the development side, as well as the fundraising side. So it's a unique combination of skills that one has to have in order to be successful in this space. And as it just so happens, we have expertise in all of those spaces, and it's why it's a good fit for us and why we pounced on it early, because it just fits what we do, right? It will catch on, there will be more players entering the space, but of course we're also the biggest player here and have started to make those relationships with local developers. We have the deal flow, and of course we also have the cap. And so putting that all together is very important.
Adam Hooper - And then, on the substantial improvement thing, to put it into, again, kind of just easy numbers to understand for listeners, to further the point of the complexity of that, if I have a million dollars, again back in this example, I've had a million dollars of gain from selling stock, if I go buy a property for a million, I have to invest an additional million in that property within the first 30 months, I believe. Right?
Derek Uldricks - That's correct.
Adam Hooper - That's going to be a pretty heavy lift for people that aren't experienced at doing that, right? And I think that is where, again, it differs from the 1031 exchange and some of the tenants in common and DSE's that we saw for that convenience factor. That's a little bit more challenging with the opportunity zones, because there is that requirement to increase the basis. So I think, like you said, a lot of what we're seeing is ground-up development, or like we were talking today, very heavy repositioning of assets. But it's hard if you're looking at doing it at scale. If you're going to buy an asset for $25 million, that's going to be a pretty big project to put another $25 million into it. I think it'll be interesting to see what the ideal profile of a deal is as this matures and we see more of these come into play. Is the sweet spot going to be the $2 to $5 million project, $5 to $10 million project? I think it'll be interesting to see where that shakes out as it rolls on.
Tyler Stewart - Does the 100% required for the improvements, is that at the LLC level or do the limited partners, if they invest 50,000, should they expect that they'll have to put in 50,000 into improvements?
Derek Uldricks - That's all handled at the manager level. So we will essentially go out and buy assets and then as we're raising capital, we're injecting more capital into it. So typically on our projects, we will improve the properties by seven to eight x through building, through going out and building something. That's typically how we're going to approach it. From the investor perspectives, they're just putting in one slug of capital. We're not coming out for additional capital calls. We can't do that, primarily because you have to invest the capital gains within that certain window. So if we went out and did a capital call a year from when we called the original capital, that next 50,000, you're not going to get the tax benefits on that, right? That's just fresh capital coming in. So we'll handle the substantial improvement requirement at the fund level and make sure that's all taken care of.
Adam Hooper - Good. And then locations of opportunity zones. I was talking with accountant this morning, and they were saying that a lot of their clients are feeling that they don't want to be restricted in geography of where they can look for these opportunities. There's a map out there that probably we'll put a link in the show notes here for the map of these opportunity zones if anybody want to take a look. But we're in Portland. Most of downtown Portland and most of the kind of inner east side of Portland is an opportunity zone. So there are some, I think, pretty interesting markets that are in qualified opportunity zones because they were using census data from the 2011 census. As we were talking yesterday, a lot's changed since 2011. Some of those geographic locations that were a little bit more challenging in 2011 have come quite a ways since then. So how have you guys seen locations of these opportunity zones, and are you focused in a specific geography, or are you going to be pretty nimble across the US in where some of these assets are going to be located?
Derek Uldricks - For us, we're focused in on three main strategies. I touched on them early on, which are residential real estate, generally, so both multifamily, single family, residential for rent as well as hospitality. Regionally, we're primarily focusing on the Southwest and the Southeast, so the Sunbelt region. We like those markets because improving demographics, those areas are also generally good places for business. So when you're doing residential real estate, of course you want to be in a place that has jobs, because where there are jobs, there's people, where there's people, there's renters, there's buyers of real estate, right? So it tends to improve rental rates, occupancy. So those are markets we want to be in. For example, Phoenix, Phoenix is a rapidly growing market. Just saw some numbers this morning. Doing really, really well. People are fleeing California at a pretty rapid pace. Texas is another place that we really like, so San Antonio, Austin, Dallas, Houston. We're in those markets pretty deeply right now. We're looking at opportunity zone assets and vetting through the possibilities. We're also really interested in certain parts of Florida. So Orlando, Orlando was a market that was actually hit pretty hard in the downturn. We have a building there that we're an investor in. So it's finally starting to come back. There's lot of reasons to like Orlando. And in Georgia, we love Atlanta. So Atlanta is obviously a big hub for business and improving demographics. It's a great place to invest. As well as certain parts of the Carolinas,
Derek Uldricks - so Charlotte, Raleigh, we're looking in those markets as well. So we're focused on those areas. We like to be in places that also are easy to develop in. We talked about this yesterday, that because the investments that we're doing in the fund are development projects, one of the key things we're going to have to do is make sure that we can get these projects done in time. So if you're developing a project in California, it may take five years for you to actually complete the project, or just substantially improve it over that period of time. Well, that's not going to work for the opportunity zone fund, right, 'cause we have to substantially improve it over 30 months. So we need to be in markets that are pro-development, that are helpful in getting us the approvals that we need in order to complete the projects on time and stay within those regulations. We will look at other markets, or we love California, we love the Northwest, we love to be in those markets. But it's got to be the right deal. We have to be certain that we can execute a plan so that we don't get out of whack with the compliance requirements that we have.
Adam Hooper - And then, so to that point, this time restriction included, what are some of the risks as an investor looking at this and maybe investing in opportunity zones, either alone or in a fund, what are some of the risk that you guys see at this point in the game that investors should be looking out for when they're reviewing these opportunities?
Derek Uldricks - I think the typical real estate investment in terms of risk, so of course you're going to have to look at market risk, so do you want to be in the market that the deal is or that the fund is focusing on? That's obviously something that needs to be looked at. You are also going to run into, of course, leverage. So because we think most of these opportunity zone investments will be vertical development, they're going to be leveraged, right? So pretty much every deal that is built has some form of financing. Looking at levels of leverage and guarantees, how credible is the sponsor? Do they have a strong balance sheet? Are they able to work through the construction? That's also something to pay close attention to, right, so execution risk. Can they do what they say they're going to do? That's also a big component of it. Other stuff, like you're going to have construction risk. So prices of construction costs have been going up, both labor and materials, so that's something to pay close attention to. I think the first movers are going to have an advantage there. There's also the concern, I think, that you're going to have a lot of people bidding up the values of properties that are in opportunity zones, right? So you have a valuation risk problem. You may be overpaying for assets. You have to be careful with that. You have to look deeply at what the sponsor or the syndicator's paying for the land. That's something to pay really close attention to. On the regulation side, in terms of how the law is structured
Derek Uldricks - and what to pay attention to there, it's really important to, of course, be with somebody and be with a group that has a firm understanding of all of this stuff. So we spent a lot of money on white shoe law firms helping us with putting together the offering documents and structuring the deal correctly. That's something that needs to be paid close attention to. The regulations are moving somewhat. From our perspective, we take the most conservative approach possible in all of our structuring, in all of our deals, as to mitigate that risk. But of course there could be other players out there that are more aggressive than we are. So that's just something to pay attention to. So doing due diligence on the statute, asking questions, talking with people who are in the industry that have an affinity for this program, I think that's a key thing that an investor should look at as well.
Adam Hooper - And again, I think by the time this episode airs, we should have the updated guidance from Treasury, right? I think it was supposed to be by end of July that they get that revised guidance out. So hopefully by the time this airs, maybe we can record a quick intro with any changes or updates that have been there. But yeah, the fundamental real estate investment risks remain. But you don't see, necessarily, a lot of additional risk that an investor would get into by investing in one of these opportunity funds or on their own in an opportunity zone?
Derek Uldricks - I think if they tried to do it on their own, I wouldn't recommend that. I think that's very problematic. There's a lot of moving parts here and a lot of regulations that fund managers and syndicators need to worry about and think about. So I would not recommend anybody try to do it on their own unless they're very sophisticated and have done real estate development in the past. That's most likely what the investor's going to be dealing with. It's just, there's a lot of moving parts. The other risks, I mean, I think they mostly relate to some of the regulations and going afoul of those regulations. So again, just going back to the fact that you have to deal with somebody who understands what needs to be done and how the reporting works and the 90% test, substantial improvement, somebody who just knows that stuff inside and out is really where you want to go. If you end up not following those guidelines, there are penalties involved. Issues with taxes that investors have to potentially be liable for. So it's serious risks. I mean, if you don't want to be in a deal that is going to have issues with that, so you just really have to vet the sponsor and really vet the deal, right, to make sure that you're meeting all the criteria of the regulation. I think that's probably the most significant risk that an investor outside of the typical real estate-related risks that they should consider.
Adam Hooper - And you said penalties. That's, I'm assuming, a recognition of that gain. Are there also penalties on top of the gain recognition?
Derek Uldricks - I'd have to go back and look at the exact penalty. I don't have them in front of me. But I believe there's, like, 10% penalty, I think, you have to pay on taxes if you mess up on some of the exemptions. But I'd lave to look back at those. I can't remember off the top of my head.
Adam Hooper - I think that's a pretty good overview. Like you said, there's not a ton of information out there about these yet. It's something that I think we'll see a lot more of. It is potentially one of the most powerful tax treatments for certainly our world of real estate investments that we've seen in a long time. And so we expect that there's going to be a lot of interest in this, and we're happy and we're thankful that you came on the show today to walk us through some of those nuances, and we're excited to see this little sector of the industry mature and get a little bit more clarity around some of the guidance and see where it all goes. We really appreciate your time, Derek. I don't know if there's anything else that you wanted to add or anything that we didn't touch on that want to get to, or anything you want to ask us. But I think this has been a great session.
Derek Uldricks - Yeah, no, thanks Adam. Really appreciate it. Obviously this is a new program. So there's a lot of questions from investors on how this all works. So we actually have some good resources on our website, virtuapartners.com. Go check it out. There's a lot of information on how the program works, good links to get other information as well on types on investments that we're working on. So I'd encourage everyone to go check that out. Yeah, I think we've covered most of it. Just happy to be on the show and talk to you guys and get more information to your listeners, and looking forward to having more conversations about it.
Adam Hooper - Perfect. Well, Derek, again, we really appreciate your time. Hope the move to Phoenix goes well. Stay in the shade once you get over there. But yeah, listeners out there, appreciate you listening to another episode. As always, we appreciate reviews and comments on iTunes or wherever you listen. If you have any questions, please send us an email to firstname.lastname@example.org. With that, we'll catch you in 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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