Opportunity Lurks in the Gray Areas

Phil Jelsma

The Opportunity Zone Expo Podcast
Opportunity Lurks in the Gray Areas


Jack: Welcome back everybody to the Opportunity Zone Podcast. I'm your host Jack Heald. I'm here today with Phil Jelsma, who is an attorney with the firm CSG, did I get that right? CSG?

Phil: CGS3, it's a mouthful.

Jack: Well, welcome Phil. It's good to have you.

Phil: Thank you. I appreciate it, Jack.

Jack: I met Phil at the offices of the Opportunity Zone Expo last week. He gave us some, what was to me, pretty impressive insight into the tax implications and investing implications of the Opportunity Zone program. And Phil, we're going to dig into that here in just a minute. But before we do that, I want to find out a little bit about Phil Jelsma, who are you? How'd you get started business?

Phil: Well, I, not surprisingly, I'm a tax lawyer. I've been doing this for a long time. Over 30 years here in San Diego at first a full-service law firm called Loose Forward that was acquired by Mckenna, Long and Aldridge, and four years ago I made the move over to a smaller boutique firm here, CGS3. Which is a real estate, a boutique firm in San Diego and Los Angeles.

And so, I am surrounded by real estate lawyers all day who love to talk and think real estate. And I have, taught now for 30 years out at USD law school. Initially on the taxation of real property. Now it's a little bit broader of course, because we do, discussions of taxation of intangibles and personal property, but it's something that, I guess I'm naturally interested in the kind of the intersection of federal and state tax policy and, ownership and management of property and, I guess is kind of a longtime advocate for redevelopment and improving some of the urban infrastructure.

I got interested when the 2017 tax bill was, first pushed through Congress and then signed by the president in December of 2017 and happened to pick up, as I've mentioned last week, the first chapter in the last chapter of the 2017 tax act has three sections on Opportunity Zones. And so, it seemed to me that was an interesting approach to try to help some of these lower-income communities attract capital.

And we'll talk today about the real estate side and as I mentioned, the business aspects of Opportunity Zones I think are in some respects are a little bit of the unexplored territory, for both investors and probably in some respects for tax people because we're still looking for some rules in terms of how these attributes and these incentives necessarily work when I own a business. So, I guess I'm referred to around here as a tax geek because, I like thinking about, I like planning for, and I like, the mental exercise of understanding how the tax rules work.

Jack: I will confess that until I heard you speak if somebody had said, oh, go talk to this tax attorney, I would have thought to myself, I'd rather sit and watch paint dry. But, that 45 minutes you gave us there in the office. It was absolutely riveting. And I think for the first time in my life I understood why this type of work would be fascinating to someone. You did a great job.

Phil: Well, thank you. It is. I think it's a matter of, in many respects, I think it's a benefit to teach in law school we tend to often make simple concepts, complicated. And I think in many respects our job is actually to go the other way and that is to try to take complex issues and complex problems and communicate them so people really understand, hear what was the congressional intent, what can be done, what can't be done? What are the benefits if you do it?

Jack: I'm fascinated. How did you end up actually being able to teach at the same time that you're practicing law?

Phil: Yeah, it's probably more of a, of a testament to my partners because they let me do it. What I bring to the law school, is a practitioner's bent to how we practice as opposed to an academic bent, which I think for better or worse traditionally is what's taught in law school.

Jack: Reminds me of Mike Tyson's famous quote, “Everybody's got a plan until they get hit in the face.”

Phil: Right.

Jack: If all you've heard in law school is academics, the real world's going to be a whole lot different. Well, let's dive into the Opportunity Zone market.

Phil: Mmmhmm

Jack: What kind of question does the person who shows up on your doorstep have when it comes to the Opportunity Zone.  When they come to Phil Jelsma and say “Hey, what do I do with here?”

Phil: Some of them are people that either have done transactions, are thinking about doing transactions and they're either nominally aware of Opportunity Zones, or this gentleman was completely unaware, kind of thought 1031 was his only avenue. And like I said, we'd had a conversation and why I thought that was going to be a difficult, a difficult road for him to pursue. But an Opportunity Zone would be an easier pass if he was interested in doing it. And so that's another place where you get people that either can't do a 1031 or they can't find the right placement property or they've got issues or he just had a difficult problem inside his 1031 transaction that was going to make it hard to be able to get this done. So, there’s that piece as well.

That’s kind of one category. You know. The other category is the clients that already own property in Opportunity Zone. Either they recently acquired it or often it's the law works so that the Opportunity Zone fund has to acquire the property by purchase after December 31, 2017. So, another avenue is people that own property in the Opportunity Zone that now want to develop it or redevelop it, but they already own it. And kind of their questions are, what do I have to do? And the simple answer is, we need to create a new entity and you need to sell it to the new entity. And you can't own 20% of capital or profits in the new entity, the buyer. But we can do some things to help you deploy your gain into multiple Opportunity Zones.

So, there's a category of clients that are aware of the law and either hopefully they're coming in saying, hey, I'm buying this property and then we can do something for them. We can form the Opportunity Zone fund and get it up and running. Sometimes they're coming in saying, well, I bought this property at the bottom of the market 2010 and now I want to redevelop it and kind of what can I do? And the answer is, well, we need to change the ownership, is the simple answer. We need to have kind of a new entity own the property, not the old entity. So that, you know there are categories of that. And then, probably the last category is, really the investor side is the developer side where a real estate developer has found a property and Opportunity Zone and he or she knows, okay, this is it. This is what I want to do. How do I go about attracting the capital to be able to acquire and substantially improve the property? So, being at a real estate firm in some respects, the clients here tend to be more along those lines is that they already, they, they develop property. They build property, they do other things and so their questions tend to be much more kind of the mechanics of what do I have to do to qualify this for an Opportunity Zone Fund.

Jack: What's the best question you've gotten from a developer in terms of the Opportunity Zone, or maybe the most interesting question you've gotten with developers and Opportunity Zones recently?

Phil: Well, the most interesting questions really get to an area that we don't have a whole lot of guidance on, which is really the question of ground leases. So we know that …

Jack: For those who are not tax attorneys define "ground lease".

Phil: A ground lease is a really long long-term lease transactions and there's kind of two different benchmarks. The federal income tax rules talk about leases of 30 years or more property tax rules. California property tax rules talk about leases of 35 years or more, but the Opportunity Zone legislation talks about the fund, the new entity that's doing the improvements, has to acquire the property by purchase. And if it does that, the seller can't own more than 20% of the buyer. The question of whether or not, rather than selling it, if I have our current owner, simply enter into a long-term lease with an Opportunity Zone fund that would either renovate or build a new property, in many respects kind of theoretically that's the most, to me, that's one of the more interesting questions.

Which is, the law says if it's acquired by purchase, here are the requirements, but is really silent on the question, what happens if the fund doesn’t buy the property? But the fund merely enters into a long-term lease and controls the property, like I said, for either 30 or 35 years. A lot of times you'll see these things, 50 years, rarely 99 years. But sometimes those transactions I think are in some respects the most interesting because like I said, they seemingly fall into this void or gap, that the law doesn't really speak to.

I think the other thing that, that I find interesting, or amusing is kind of the whole question of, if the fund has a subsidiary, there are limitations on what businesses the subsidiary can be engaged in, what we refer to as sin businesses. Like, private golf courses, massage parlors, hot tubs. So, kind of the whole question in California that, and the delineation of what sin businesses are, cannabis isn't included in being in a state where marijuana is legal, and whether or not that was an intentional or unintentional, oversight.

When you heard Secretary Mnuchin's comments about it. Well, gee, I certainly wouldn't want to run a cannabis business in an Opportunity Zone. Okay, well I get that he's the Secretary of Treasury, so I understand why he wouldn’t want to do that. But, whether or not that's an indicator that was an oversight and that they meant to include it in the definition of sins and didn't, or whether or not that was just, we didn't include it because the states are in the process of gradually legalizing it state by state.

So, that's another interesting debate or discussion inside the kind of the Opportunity Zone world is what, what is omission, what does not include something mean that we meant to do it, which is kind of what he's saying. and therefore you should think it's in there or do you take more of a literal interpretation? While if you didn't say it, you didn't mean it. So that's another, another kind of interesting that debate or discussion.

Jack: I would think that with literally every other previous administration’s failure to spell these things out could be taken as literally nothing more than a failure to spell it out. Whereas, with the Trump administration given his background as a developer, is it possible that it's more likely that the silence itself was intentional?

Phil: To be honest with you, I just don't think they thought about it. I think in some respects it was an oversight. Now having said that, once you leave it out and you want to try to bring it in, then of course, the lobbying really, really comes about. Because, generally, I'm not sure other than kind of the establishment of saying, yeah, it should have been in there. I think you're going to have kind of the forces in the western states that are part of this industry really move to try to prevent Congress from adding them in.

Jack: Well, that leads me to my next question.  Which is in light of all these, for lack of a better word, very ambiguous directions from the government, how do you manage the concerns that their silence raises for a potential Opportunity Zone investment?

Phil: Well, one possibility, which actually sometimes solves itself is the, for example, the prohibition on sin businesses really say that the Opportunity Zones subsidiary can't be engaged in these businesses. What it doesn't say is you can't lease to tenants in those businesses. So, oftentimes, if the reaction is, well, gee, the entity itself can't do it, then, that doesn't prohibit us from using having attended to it.

This almost gets back to the ground lease discussion. In many respects the IRS historically has tried to find ways to attribute activities of one party to another. And that's typically through related party rules, where they've always had a problem and they've always been reluctant to go. There is trying to attribute activities of tenants to landlords or from landlords to tenants because, generally speaking, those people are in two separate businesses.

So as a result, like I said, the prohibition on sin businesses tells me that the, Opportunity Zone sub can't be in the business but doesn't prohibit me from leasing that space to a tenant who's in that business. and it seems to be silent on that. And like I said, I think that's a little bit of a reflection that historically, the IRS and in some respects Congress, so the IRS has always found it difficult to say, well, just because your tenant’s doing something, you, the property owner is, is doing it. And so I think they've always been very respectful of that line. And so to get to the point of, well, Gee, if I can't do it, does that mean that my sponsor or my lead investor or some someone can't form a business that, let's say operates, a retail cannabis, a facility in California and that, that particular and, investor, forms an S Corp, C Corp, Partnership, LLC and that becomes a tenant in my space.

Um, there doesn't seem to be any prohibition on that. And then, the kind of close the loop is, there's nothing that would suggest that if I did that, that that entity, the S Corp, the C Corp, that owned the other, operated the cannabis business. As long as it's in the Opportunity Zone, it would seem to also be entitled to the same benefits that the real estate gets, which is it could be owned by a separate Opportunity Zone fund. That fund could just invest in that particular business instead. So, like I said, they're always, what kind of makes this area of law, or in general, kind of interesting is there's rarely black and white. It's always shades of gray and kind of, if the prohibition is here and I can't do this, is there another way to structure the transaction that I don't run afoul of that prohibition. That kind of saying, well the Opportunity Zone sub can't do it, but it doesn't prohibit tenants from doing those kinds of thing.

Jack: Typically, the folks I talked to are not on the tax side here. And so when I say to them, what's your single biggest concern about the Opportunity Zone, they talked to the areas where the law is vague.

Phil: Uh huh.

Jack: And it's, I have to say, it's really nice to hear someone who doesn't seem to take the vagueness as a particularly overwhelming concern.

Phil: I like the shades of gray. I like working in that, in that world. I like the fact that there aren't, there aren’t, bright line test. I, unlike how, I mean I understand why the investors would like that and kind of complete assurance. But I think when you're a planner and you're a transactional lawyer and you're trying to put these deals together, like I said, I like the shades of gray. I like, that there aren’t a complete set of set of rules that allow us to kind of say, okay, here are, here are the rules we've got now how do we move? How do we move? How do we maneuver inside of that?

Jack: What has been the most pleasant surprise that you've encountered as you've dug into this law?

Phil: I used to work with a guy who always said, it’s always better to be lucky than smart. And the most pleasant surprise I've had is, the clients, the developers who didn't get into an Opportunity Zone deal or get one under contract with the thinking of: “Oh gee, I'm really going to take advantage of this,” but kind of, it fell into their lap and kind of in some respects, whether it's the reaction, the joy or something else, it's like getting a Christmas present. And it's like, it's fun for me to be able to deliver the Christmas present, play Santa Claus and say, well, maybe you didn't really think about this, but here’s an alternative for you.

Jack: What are the most important questions an investor needs to be asking before he gets involved with the Opportunity Zone program?

Phil: Well, it's really fundamentally, whether it's real estate or a business investment. It's an investment. And kind of what I'm constantly telling people are reminding them is it doesn't make any sense if you don't have gain on the property after 10 years. And I'm kind of constantly reminding people, well, the answer, the right answer isn't just dumping some money into an Opportunity Zone fund. The right answer is to do your due diligence on the sponsor, on the developer and on the property. Because if you don't make money and it was all for not, it was all kind of just an academic exercise. So, I think, to me, in some respects, I think the thing that I'm constantly reminding people is it's just not a tax, it's not just a tax deferral scheme.

You shouldn't be driven simply by trying to defer paying your taxes. It's a real estate investment and it's only as good as the real estate is. And if you're going to buy a building in a bad neighborhood and spend, $1 million, $2 million, $3 million renovating it, the question is: Can you raise the rents enough to be able to pay those costs? If not, it's probably going to have negative cash-flow. It’s not going to be close to stabilization and you're going to be putting, more and more money into it.

At its very simplest, at its very basic opportunity are sticks and bricks. This is a brick and mortar type of investment that we're going to be talking about. And yeah, there are mechanical rules, but I can't think of anything more simple than reminding people you got to buy the right property, in the right neighborhood, with the right contractor, and the right developer and the right economics. And it is as basic as Real Estate 101. Because if it's not a good property, if it's not a good project, you're not going to make money on it. If you don't make money on it, you're not gonna see any benefit from the Opportunity Zone.

Jack: So, what is it that you are best at?

Phil: I think what I'm best at, and I think in some respects that's more of a reflection of having a practice tax law for 32 years. What I think I'm best at is trying to assemble a complicated puzzle or development and understand kind of how the various pieces either interact or interplay or don't interact. We've got to another real estate lawyer here that I work with a lot, Dennis Ship, and he was really fabulous at this, really taking kind of a complicated set of problems and being able to assemble it so that you have a workable project. And to me that's, something that I enjoy. But I just think the reality is, that’s literally the school of hard knocks. Those are the things that, that you have to learn by experience, by trying and failing and trying again and failing again.

And then, maybe getting lucky and saying, okay, “Well that works now. What's the next problem?” And seeing how we can make that work. So anyway, that you learn a lot from going through the cycle and going through the bad times. And one, you learn to appreciate the good times, but you also get to understand, behind every silver lining is a dark cloud. And you also, recognize that, what goes up will go down and the market's kind of always on a roller coaster. And the fact that the roller coaster's going up or staying level doesn't mean it can't go down again.

Jack: Well, let's ask the opposite question. We would talked about what you're best at, what drives you crazy?

Phil: Sometimes what drives me crazy or drives me most crazy is where there is a common sense approach or a common sense answer, and someone says, well, we can't do that. We can’t do that because of this rule. We can't do this, that because of this regulation. If someone's willing to step in and make the investment and take the risk, why are you opposing it? But you'll see a lot of that go on. And it’s, whether it's a form of NIMBY-ism or it's just opposing change, well, it's a broken-down building. Yeah. But it's a historic broken down building while it's a broken down building is really what it is. That, that to me in some respects, that's the real, that's where I get, I get frustrated. Um…

Jack: Yeah, so if you were a betting man. What part of the Opportunity Zone program do you think is most likely to be changed and I'm thinking particularly after we get past the end of 2020 where the tax benefits of 15% step up in basis at this point, anyway is going to go away?

Phil: That's a great question. I think it's going to be, it's going to be interesting. You heard in the first set of a commentary on the regulations that people said, well, wait a minute. There’s a kind of a fundamental on the design that I have to pay the tax, for the asset I sold in 2026, but I can't sell the Opportunity Zone own property for 10 years. So, if I did it in ‘18, 2028 at the beginning, at the earliest, if I'm investing in 19, 2029 at the earliest, that differential which causes a liquidity issue for both the investor and sometimes for the funds with the funds want to address it.  
I think that, in some respects I think that a kind of a design flaw in my mind that I think ultimately there's going to be some pressure, to find a way to move the tax liability on the property I sold to when I'm selling the property in the Opportunity Zone. I think in some respects that's the, that's the piece that at, if there's going to be a change, I think there's going to be kind of a call for, well, let me defer my tax, but let me, let me pay it when I saw my property in the Opportunity Zone.

Jack: Yeah, that makes a lot of sense. Well Phil it has been a really good conversation. I appreciate it. Is there anything else? Something else?

Phil: No, I mean I, no, no, no. I really enjoyed it. You asked great questions. And I'd love to it again. like I said, this is an area, I mean in an hour, you literally scratch, scratch the surface.

Jack: Well Phil, how can our listeners get ahold of you. What's the best way to get ahold of you?

Phil: Well, it's really just my email address, which is pjelsma@cgs3.com. So, Charlie, Gordon, Sam, then the number three.com. That's the best way to said to get ahold of me. I, I will try to, I can't make any complete promises, but I always try to respond to all the emails by the end of the day. So, I'm always happy I, and like I said, new problems are fun problems. The same old thing is sometimes repetitive, but it's always, it's kind of always nice to hear from the audience, what are they worried about? What are their concerns?

Jack: I do want our listeners to know that this information is also going to be available on the website so you can just click on it. You don’t have to write it all down right now. We’ll Phil, I have certainly enjoyed hearing from somebody who knows the ins and outs of the program the way that you do. I am Jack Heald, for the Opportunity Zone podcast.  I want to thank Phil Jelsma for being here with us this week. We will talk to you next time.

Announcer:  This podcast is for informational purposes only and does not constitute legal, tax, or investment advice.  For specific recommendation please consult with your financial, legal or tax professional.  

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