Jack: Welcome back everyone to the OZExpo Podcast. I am your host, Jack Heald and I am joined today by Eric Kodesch who is a partner with the law firm of Lane Powell. Eric, welcome to the OZExpo Podcast.
Eric: Thank you so much.
Jack: It's good to have you here today. Now I'll let our listeners know that both Eric and I are going well above and beyond the call of duty. This podcast is being recorded on July 5. We should both be on vacation. And yet here we are bringing this brilliance to our listening audience. I do thank you for going out of your way to do this today, Eric.
Eric: Oh, happy to kind of be part of this.
Jack: Give us a real quick high-level professional biography. You are a partner with Lane Powell. Tell us where Lane Powell is located and your area of specialty.
Eric: Sure. Lane Powell is primarily in Seattle and also in Portland. I'm in the Portland Office. We also have an office in Anchorage. My specialty is tax, kind of general anything tax with federal and the new Opportunity Zone. I also do a lot of estate tax planning and litigation in Oregon and - to the extent possible - delve into international tax issues.
Jack: Very good. I want to ask you a question because my business is words. And this has nothing to do with anything other than I'm interested in it. The word regime
is used in reference to taxes. And the only other place that I ever hear regime
used is the context of some sort of a military government intervention kind of thing. Is that just a convention in the tax community?
Eric: I think so. I never actually thought of it, but that's a good point. But we do always use “regime” for kind of different areas like “the Opportunity Zone regime.” It's just kind of that subset of the tax law that just has its own specific rules and kind of unique things you have to follow. I never really thought of it as a militaristic one, but, it is kind of very that rules.
Jack: Well, if somebody from the government is listening right now and needs a little rebranding and marketing help – which is my area of specialty – I'm going to give this one away for free. Stop referring to your tax stuff with militaristic terms that don't make people feel happy and excited to engage with you. That's just a bad, bad choice.
All right, back to you Eric. Let's jump right into to the meat and potatoes of your specialty as it relates to the Opportunity Zone program. I was doing some research prior to the show and you made a comment in one of your articles that made me realize something. I've never asked this specific question and you're clearly the right guy for me to ask. You said that a taxpayer's investment in a Qualified Opportunity Fund must be bifurcated if the taxpayer invests amounts other than the deferred gain in the fund. I failed to specifically ask that question of any of my other tax attorney guests. And I'm glad I found this. Expand on that statement for us.
Eric: Yeah, absolutely. And this is what the IRS refers to as a mixed fund investment, which I always thought was a strange term because this idea of mixing funds and the basic notion is that the Opportunity Zone tax benefits are only available to the extent that you're rolling capital gain into the investment. For various reasons, people might invest amounts that are not just capital gains. It could be that the investment requires more than the gains the person has.
Eric: So you need to make a $3 million investment. You have $2 million in capital gain and the other million is just not capital gain. Or it could be that somebody's instead of investing cash, make no transfers property. And the property has a fair market value in excess of basis.
That also is a mixed fund investment. And so the whole idea of bifurcating is you have one investment that's made with your capital gain proceeds and then you have a separate investment made with the proceeds that are not capital gains. And so, you have to get into the idea that now only part of your investment is going to qualify for the Opportunity Zone benefits.
Obviously if you're investing cash that's not from capital gains you're not worried about deferral and you're not worried about eliminating up to 15 percent, but when you sell your investment after 10 years, you only get the no tax on appreciation benefit for the portion of the investment that was made with capital gains from Day 1. And so…
Jack: Okay, so if 60 percet of the funds I invested were from cap gains, then only 6of the sale price is going to be, is going to be subject to the, the step up to market value.
Eric: Correc. And I mean this bifurcation gets a lot more complicated, even more complicated. And again so what I've seen with clients so far is everyone's investing cash equal to the capital gains. I haven't seen people make investments beyond the capital gains they have because there's just a lot of capital gains out there. And I haven't seen people want to use property, but even more complicated is you invest in this Qualified Opportunity Fund and that is one investment and you have an interest in one entity but you get into the complication of, to the extent your investment is made with capital gains, you start with a $0 outside basis cause you're using untaxed money.
Eric: But if you also use just savings that we, or if you make an investment beyond your capital gains, well then that's just an investment in a partnership. Assuming the Qualified Opportunity Fund is going to be a partnership, which is the norm.
Eric: And so now you do have outside basis for that just like you normally would with an investment. And there's a lot to work through in that because you have a single investment but it's being divided from Day 1 on outside basis, which is then going to have an impact on what can be, you know the impact of losses or deductions that are flowing through to you. And then when you sell it, there's an impact on, on how much of that is going to qualify for the no tax on appreciation. And so, there's a lot to work through, which is probably why people are people are limiting their investments generally to their capital gains.
Jack: I want to follow up on something you said about, about using property as the investment. How technically would that work since the investment in a qualified Opportunity Zone has to come from a capital gain? Do you just create some sort of taxable event on paper in order to move the property into a QOZ or QOF?
Eric: No, it really has more to do with the fact, and this is one of the team benefits of the Qualified Opportunity Zone program. I'll try not to use the word regime. Compared to something like a 1031 exchange is that there's no tracing of the gain. It's not it's not like you have to you sell stock or whatever other appreciated property and we're tracking the dollars. The idea is during the year you have capital gain of X from whatever you have. And then you have to make an investment in a Qualified Opportunity Fund of X.
So you could easily have a situation where you sell property for cash, you know and you have you have $1 million in gain and $1 million in cash, but you don't have to invest cash and the Qualified Opportunity Fund you can transfer property, you could transfer stock.
Jack: Oh OK, I got you. So, you've, you've, I've, I've got $1 million cash sitting here on, on my desk because I sold property a, I have property B that happens to be worth at market value $1 million. I can actually invest property B.
Eric: Yes. Except it's not what it's worth.
Jack: Transfer ownership or go, okay.
Eric: It's that you have property B with a basis of $1 million.
Jack: A basis of $1 million. Okay, gotcha.
Eric: And that's why if property B as a basis of $1 million but a fair market value of $1.5 million. If you put all the property B in the Qualified Opportunity Fund, now you have a mixed fund investment.
Jack: Oh, now we got to bifurcate that puppy.
Jack: Wow. This does get complicated.
Eric: What you're seeing first of all, if you've got one of the widely held kind of investment funds or hedge fund type structures where they're getting minimum investment of $250,000 or $2 million or whatever their minimum is, I haven't seen them being willing to take property. Those were normally going to be cash investments.
Eric: So, it's really when, and then if you've got your own Qualified Opportunity Fund, it needs cash because it's going to then invest in a lower-tier entity. And I believe – I'd have to double check – but I'm fairly certain that the Qualified Opportunity Fund has to use cash to acquire its interest in a lower-tier partnership or corporation. I think the code is specific on saying that the interest is an interest acquired by the Qualified Opportunity Fund for cash.
Jack: Gotcha. Yeah. Now that you mentioned it, I think I remember that specific verbiage because I'm not a tax accountant or a tax lawyer. I really wasn't paying attention.
Eric: This has creates its own implications because if you have to do things with cash , you can't do it for a note. You can't. There's all kinds of weird stuff that can happen, but the taxpayer that invested in the Qualified Opportunity Fund does not have to invest with cash.
Jack: Almost anyone who's listening is very familiar with the broad outlines with the Opportunity Zone program: the 10 percent and 15 percent step up in basis, the 0 percent tax after 10 years. Have to pass the 70 percent and 90 percent test.
One question I haven't asked here is about the penalties. If in fact you fail to meet the 90 percent asset test on the applicable testing dates, what are those penalties? Have they been specified? And what are your opinions about the efficacy of those penalties?
Eric: So, they are called penalties. But you know, they're not harsh. One of the themes that anyone who's studied this, this program is incredibly taxpayer friendly. The IRS is doing everything to make it as friendly as possible and Congress did as well in creating it.
And the, the, the so-called penalty is essentially the interest on the deferred tax. So you have in 2019 capital gain, you invested in a Qualified Opportunity Fund. So, you're now deferring recognizing that capital gain and your differing when you pay tax. The penalty is just interest on the deferred tax liability. Using the normal underpayment rate that applies under the code, which is a market interest rate.
It is not a penalty interest rates. So, they call it a penalty. And again, I haven't had had the opportunity to really work through it because this is so new. We haven't had clients yet who failed to satisfy the tests, but when you review it and when you look at it, it's really not much of a penalty. And I did have a client that wanted to use the regime. He had gains from the end of 2018 so he had a 180 day period starting at the end of last year.
He just wasn't able to find the investment and so had to you know, kind of file the amended return to take into account the 2018 gain. And you know, the penalty was simply the underpayment interest rate.
So, nothing person got technically penalized, because they call it a penalty. But at the end of the day, there really no worse off assuming they were able to earn a market interest rate on the cash.
Jack: Right. Certainly not in consequential, but definitely not a punitive.
Eric: Correct. It's not like 1031 where if you screw up the whole thing's over. Ah, you will get no deferral, pay you have to pay the full tax and you're done here. You know, if that client had wanted to keep looking and you know you know, it was just, they one thing fell through, but there was another opportunity they could have just paid the interest on the deferred tax liability made what would essentially be a late investment and it and they would have been, and as long as they had qualified by the next testing date, the whole thing would have been preserved.
Jack: Let's go specifically to your area of specialty. You know what? I am not going to spoil it for the audience. As it relates to the audience that is listening about Opportunity Zone with foreign investors.
Eric: Yeah. So, so one of the big questions from day one on looking at this regime is how's it going to interact with FIRPTA, the Foreign Investment in Real Property Tax Act, which is from the from 1980 and you know, as you and you know, kind of your audience know.
I mean the low hanging fruit for Opportunity Zone investments, the first thing everyone's doing is real estate. You know, you're going into those zones, buying and building commercial and residential rental real estate. and so now the question is as well what happens if some of those investments are going to be if foreign money comes in and will non us people be able to benefit and how will it work with FIRPTA and, and you know, as a quick overview, so the, the, the deal with FIRPTA is, it's, it's, it's two things.
There's section 897 of the code and what section 897 does is it is as a general matter, if non-U.S. people if they have capital gains, the U.S. doesn't tax it. So you can have foreigners who are trading every day on the U.S. stock markets. and there's just no gain on that.
The exception is if that game is what's considered effectively connected to a U.S. trade or business. But again, if you're just doing personal investments, usually they're not. And so, section 897 of the code comes in and just says for non-U.S. People, their gain on the sale of U.S. real property or what's actually a UF property interest, which is its own defined term. But for right now we'll just treat it as land in a real problem.
U.S. tax is gonna just say that is we're going to deem it to be income that's effectively connected to a U.S. trader business. And what that means is they, they are subject to tax on that in the exact same way as any U.S. person. Okay. And then the other part of FIRPTA is section 1445 of the code, which is a withholding regime which just says if you are buying a U.S. real property interest from a non-U.S. person, you have to withhold and pay over to the IRS 15% of the sale proceeds.
And that 15 percent is like income tax withholding. It is a credit. there are there are some exceptions to not having the withholding and you can even go to the IRS and explain that you know, your gain and your taxes well under 15 percent and you can get the IRS to agree and they'll issue a letter saying reduced withholding as necessary. But leaving that aside…
Jack: If you’re the seller, you're the seller.
Eric: Yes. If you're the seller and the buyer. So, but leaving all of that aside, the idea here is that you've got a non-U.S. person who may not have any other connection to the United States. They're are going to have some gain from the sale of real property. The U.S. wants to tax it, but if they don't have, and if the seller doesn't have any other connection to the United States it'll be hard for the IRS to go get the money and make them file a return. And so Congress came up with this, well, we'll just have the buyer withhold and the buyer's gonna withhold an amount that is in all likelihood more than the tax up. And then the seller can file a tax return and get a refund. Again, just like income tax withholding.
Eric: Your employer withholds and pays over. For most people, the income tax withholding is more than the tax they owe. And then when they file their tax return, they get a refund.
Eric: So then the question is, well, wait a minute, what if that foreigner invests in a Qualified Opportunity Fund where that fund is just going to be investing in U.S. property. Now again, normally if a foreigner has an interest in a partnership that owns real property then you know, that's a, that's considered a U.S. Real property interest in FIRPTA applies. But you know, what if they, what if the foreigner rolls capital gain into that investment?
Jack: Exactly. And what happens then?
Eric: And, and you know, and then so clearly in the there's a few questions.
So, first nothing in the Opportunity Zone um statutory language or any of it is limited to U.S. people. It is it is taxpayer. So there's no inherent reason why non-U.S. people couldn't use it. And you know, and we have treaties with several countries in those treaties generally say that each side agrees that they won't treat someone from the other country any worse than they would treat their own citizen. So it'd be we'd have treaty problems if, if the Opportunity Zone program discriminated against or treated foreigners worse off.
Eric: And again, it's one of the things to always keep in mind is the whole Opportunity Zone program basically turns off the whole capital gain regime to the extent your capital gain is from investing in the qualified Opportunity Zone after 10 years.
Jack: Yeah, right.
Eric: So, if it turns off capital gains to U.S. people that it should turn off capital gains to foreign persons where you know, their biggest capital gain issue in the U.S. is real estate cause the FIRPTA. So conceptually, there's really no reason why the Opportunity Zone program shouldn't over rule FIRPTA. Just like it overrules capital gains in general.
Jack: Makes sense.
Eric: Where things get tricky is, so if you have…
Jack: I knew there was going to be a “but.”
Eric: If you have a foreigner who sells U.S. real property, that's the gain. That's the transaction that triggers the gain that they're going to invest in the Opportunity Fund. Well that's easy. They're taxed just like U.S. people on that sale. So just like a U.S. person, they should be able to do a 1031 exchange or they should be able to roll the gain into a Qualified Opportunity Fund and not have tax.
Where it gets more interesting is, what if the foreigner selling has capital gain from a transaction that the United States wouldn't tax in the first place?
Jack: Right. That was the question I saw you raise. And I'm really interested in that.
Eric: And you know, there's no clear answer. I but the basic idea is, is you have a you have this non-U.S. person, maybe they own Apple stock and they sell that. Maybe they own stock traded on the exchange of their home country. Maybe they own real property in their home country. Whatever it is they're selling property, where there'd be no U.S. Tax on it in the first place. Can they can those proceeds? And what it really turns on is the whole Opportunity Zone program, the statutory language, is that your investment has to be with gain - that it is a gain that is recognized. I think it's recognized, not realized, but can double check on that.
And my personal view and, and I wrote an article about this, is that whether the gain is recognized or realized – again, sorry for forgetting which of those words – turns on a 1001 of the code and nothing in that ever says it has to be taxable. I would say that when a non-U.S. Person sells stock on the U.S. stock market, they have gain. It is recognized under U.S. tax law. It's just not taxed.
Jack: Oh wow.
Eric: And nothing in the code, yeah. Nothing in the Opportunity Zone regime says it's gained that would be tax. I think it's gained that would be recognized. But for this regime.
Jack: Does this feel like a great big hole you could drive a truck through for a select subset of investors.
Eric: I don't think so. I mean because we're not taxing their basically just means these people don't get to benefit from the deferral because there's no gain there. Cause there's nothing to defer it. Right. And there's, there's and they don't they don't get the elimination, cause again, there's nothing to eliminate, but at the end of the day, the whole point of the reason for the Opportunity program of regime is to stimulate investment and create jobs in Opportunity Zones. So why is it any worse too?
I mean, in some ways I actually think it's better because if you think of the U.S. you know, for U.S. people it is gain that would be taxed on day one gets deferred and partially eliminated. So you get this huge haircut and then never taxed again. With foreigners it's money that wouldn't have been taxed ever and isn't going to be taxed.
But it gets to come into the U.S. and it gets to be used to create the jobs that the whole regime was created to whether it's if you want, if you want to have jobs in the zone or you want to have low-income housing, which was kind of the motivation behind it. Why should it matter if the, if the people funding it are U.S. or foreign? And why should it matter if they're funding it with money that the U.S. would attack the end of the day you have the jobs and you have the low cost housing that this whole thing is designed to create.
Jack: Okay. So I probably used a phrase that gave you the wrong impression of my meaning when I said a hole big enough to drive a truck through. I meant a hole of an opportunity, an opportunity for the foreign investors that that isn't available to a U.S. investor. As I understand it. Now this is where I'm probably confusing myself. The foreign investor has an investment to make from a sale that is recognized. And that's the phrase that this whole thing is turning on. But because they're a foreigner, that recognized transaction wouldn't be subject to taxation in the U.S. therefore they get no benefit from the deferral. But they still can invest that and get the benefit from the, they can't get the 0% taxation benefit on the cane.
Eric: No though after 10 years, yes.
Jack: They, they still can. So, they can get that. Yes. So, I am right. I am understanding this. Correct.
Eric: Oh no. You're understanding it. Correct. And, and I guess my point is that after 10 years it is a huge hole, but it's no it effectively repeals FIRPTA. I mean it makes it so that you know, FIRPTA no longer applies. But how is that any different from the fact that for the U.S. people capital gains no longer applies? Exactly. And, and so, I mean it is, it's just treating non U.S. people. It's providing the same benefit that U.S. people have.
And you know, for U.S. people what we would refer to it as is basically nullifying capital gains taxes and it also nullifies capital gains taxes for foreigners. But because those capital gains taxes are all through the FIRPTA regime, then we would just say it's nullifying FIRPTA. We all known agree that the Opportunity's own program basically repeals the whole capital gains regime to the extent that you as person invest in and through the Opportunity an Opportunity Zone Fund or Qualified Opportunity Fund.
There are no capital gains after 10 years. For non-U.S. people it would be the same thing. No capital gains after holding the investment for 10 years. And the only differences are that because the capital gains tax on non-U.S. People is primarily through FIRPTA. We get to we just say it's a repeal, a FIRPTA rather than a repeal of capital gains.
Eric: But the net result is the same. And you know, there is one of the things kind of think about in fairness is if let's say let's take someone from the U.K. cause we have an income tax treaty with the, with the United Kingdom. So you have two taxpayers, they both own stock, whether Apple, Google, IBM, whatever you want to call it, both on the same number of shares of the same stock that's traded on the same U.S. stock market.
They both sell that stock have equal gain. We all know for sure that the U.S. person can invest that gain into a Qualified Opportunity Fund. You know, get the referral, get the haircut. But more importantly than anything else, get after 10 years, get the fact that there'll be no tax on the appreciation in the in the Qualified Opportunity Fund. Well, if the U.K. person does the same thing there, there's kind of a basic fairness that that U.K. person should be able to also have no tax after 10 years. No, no. One thing I should say it and you know, keep in mind is that that's my view.
I know there's others out there and I think someone recently wrote an article that there would be case law supporting it on the idea of if you don't pay tax on the gain it's foolish to say you recognize it, but you don't have to pay tax.
The whole point of recognizing gain is to tax it. And the whole life, you know the all of our tax free transaction statutes are about allowing you to, to not recognize the gain. So there will be some, and you know, that we'll say that because the non-U.S. person doesn't pay us tax on the gain that's invested in the first place, can't pay U.S. Tax. U.S. Law doesn't allow it, that that's effectively the same as it not being recognized.
And that gets us to one of the big issues. And one of the things I always have to warn clients about the Opportunity Zone investments, which is as you know, the IRS has done a great job with, it's two rounds of regulations and they've created brought a lot of certainty to things, but there's still a lot of uncertainty about questions and issues.
Right now, we have an IRS and an administration that is really favorable towards the Opportunity Zone regime. No one really knows what the landscape's going to look like in 10 years.
Eric: And it's one of those things that I can't guarantee that a foreigner won't have to pay tax after 10 years. I don't think the foreigners should, but in 10 years you can imagine a completely different view of the Opportunity Zone regime. One that doesn't view it as something that was encouraging investments to create jobs, but one that views it as some kind of giveaway. And so you just never know what the future IRS might try to seize on to, to try to call back some of this benefit.
Jack: We don't want to be used in that, that word in this context.
Eric: It's a risk that's out there because, and that's why people are scared with all the uncertainty.
Eric: Because if there's uncertainty, that means you know, a future I wouldn't if we knew we had the exact same view of it. And again, I personally, I tend to think that there's a lot of bipartisan support for this program. So that's why I don't think a future administration, regardless of which party's in power, is going to turn on it. But again, I can't guarantee that.
Eric: And so you just so you know, everyone has it. You know, and most of the investors I've worked with and clients I've worked with on this, I mean they know that, I mean that risk of future tax law changes are just part of the risk of any investments.
Jack: Right. Well, we've come to that time where I have to say about time to wrap it up, but I want to make sure that I'd give you the opportunity. Any last words for listeners that you want to make sure they hear?
Eric: It's getting exciting that I am starting to have clients who are going beyond just developing the real estate and you know, some who are going to start businesses in the zones and be franchisees and kind of actually use that space that is just being created everywhere.
Jack: Well, so that begs the question, how do people get a hold of you? What's the best way to get ahold of you?
Eric: Absolutely. So probably the easiest for listeners is just my law firm, Lane Powell, I think you will have access to it and just go online and you can find me there. But again, I can always be reached. My phone number at work is (503) 778-2107 and then my email, which is my last name and first initial, so Kodesche@lanepowell.com.
Jack: Well thanks so much Eric. I appreciate that. And for our listeners, this information Eric gave us will be printed on the podcast website so you can go there to get it just a just in case you happen to miss it. I appreciate your time today, Eric, especially on this day after Independence Day. Go back to your vacation on behalf. On behalf of the Eric Kodesch Ship Lane Powell, I am Jackie for the OZExpo Podcast. Thanks for joining us. Be sure to hit that subscribe button so you're updated when new episodes are published. That happens all the time. And 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 recommendations, please consult with your financial, legal, or tax professional.
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