What happens to opportunity zone capital if the qualified opportunity zones fund sells? And how does reinvestment of those proceeds from that sale occur before the end of a 10-year holding period? These questions and more present unique opportunities for alternative investment options with significant tax benefits.
Click the play button above to listen to our conversation with Jeff.
- Who is eligible to benefit from the OZ tax incentives.
- What gains are eligible for deferral, when investments in Qualified Opportunity Funds (QOF) must be made.
- How to transact a sale and recycle the original gain within an OZ investment in order to maintain qualified opportunity zone investment status.
- How qualified opportunity funds can remain an option for deferral of capital gains within noted time frames.
- Timeline of the tax benefits, operational requirements of the fund, and exit strategies.
- Multifamily as the largest asset class within the opportunity zone wrapper.
- How to achieve the full tax benefits in the 10-year hold period.
Featured On This Episode
Industry Spotlight: Pinnacle Partners
Since the inception of the Opportunity Zone legislation, Pinnacle Partners has been actively identifying and participating in qualifying real estate projects in attractive urban designated Opportunity Zones. Pinnacle is a source of strategic relationships for JV Partnerships with actionable opportunities in targeted Opportunity Zone markets.
Learn More About Pinnacle Partners
About The Opportunity Zones Podcast
Hosted by OpportunityDb.com founder Jimmy Atkinson, The Opportunity Zones Podcast features guest interviews from fund managers, advisors, policymakers, tax professionals, and other foremost experts in opportunity zones.
Jimmy: Welcome to The Opportunity Zones Podcast, I’m your host, Jimmy Atkinson. Today we’re gonna be talking about recycling OZ capital, what that means and how reinvestment of proceeds from an OZ investment can still keep its status as a QOF investment not lose any of the associated tax benefits. Joining me today to discuss this topic and more is Jeff Feinstein. Jeff is managing partner at Pinnacle Partners, and he joins me today from Seattle. Jeff, welcome to the show.
Jeff: Hello, Jimmy. I’m very pleased to be with you.
Jimmy: Fantastic. Pleased to have you here with us. Jeff, we just did a webinar just a few days ago and that went quite well, I think, and we’ll touch base on that a little bit later in the show today and discuss your new opportunity zone fund. But first, I wanted to talk about the concept of recycling opportunity zone capital. If a deal inside of the qualified opportunity fund ends up getting sold, what does that mean? How does reinvestment of those proceeds from that sale…and in this case, we’re contemplating a sale before the end of a 10-year holding period. What happens next so that those proceeds don’t lose the status as a Qualified Opportunity Zone investment for your LPs?
Jeff: Yes, so maybe some context and background. Pinnacle Partners has been an early mover in the execution of the OZ legislation. We seized upon this in ’17, as it was being legislated with support from tax and legal advisors, and OZ compliance experts, we were able to execute as early as 2018. It was 2019 when the regs were finalized, but all ambiguity was removed. But again, we took a little bit of risk but I think it was a calculated risk to get involved and execute early. And so indeed, we are a JV equity investment firm dedicated to OZ investing. We seek the highest quality projects in those zones, working with best-in-class developers. So we become the LP equity, the qualified equity to capitalize an OZ the project.
Having said that, because we represent our investors and we’re, you know, stewards of their capital, we’re desirous of, one, delivering the highest rate of return, two, ensuring that all investors enjoy the associated tax benefits granted by the OZ legislation. And we think, and I think you agree, these are the largest tax benefits to investors that the U.S. government has ever provided. So, the most significant of those benefits include tax elimination, which is accomplished after a 10-year holding period. There are many other compliance requirements that, of course, you’re well aware of that include substantial improvement. But suffice it to say the tax elimination, or qualifying for tax exemption after the 10-year hold, is extraordinarily compelling.
So, with that as background, and again, acting as a steward for our investors, we provide the optionality to exit early from an OZ if our investors provide supermajority consent, and of course, you might imagine this has to be, frankly, a compelling and substantial return opportunity for all of our investors. So, the first project that we partnered and capitalized was a workforce housing project in the Seattle Historic District. It was positioned to be supporting, we call it kind of 60% to 75% area medium-income renters who wanted to live near work and have a multitude of transit options. And we were providing housing in this particular sub-market that’s otherwise sparse. So, the investment thesis had an impact orientation and solid returns for sure. So, we were delivering workforce housing to this important sub-market.
We had permits, we broke ground, we went vertical on the site, and we were nearly completed when we received an unsolicited offer from our county jurisdiction, that is King County, who in an effort to support those that can’t obtain housing so readily if not homeless, they have been acquiring assets to provide transitional housing. And that has included extended stay hotels, other pre-existing apartment buildings. And in our case, a new construction opportunity well located near a variety of services that could also be supporting this community. So, this unsolicited offer was reviewed and evaluated and we presented to our investor base, and again, unanimously approved the sale to the county, and that has since closed.
So, we got to work fast to determine what we could do to recycle the original capital gain, and protect the OZ benefits that our investors fully expected and had begun to enjoy. So, again, with great support from our tax advisors, and OZ experts, we learned the following, that within an OZ investment, you can transact a sale and recycle the original gain. So, the original investment can be to use a kind of another real estate term rolled over and into another opportunity zone investment. And in doing so, you get to retain…in this case, it was a 15% step-up, you get to retain the 10-year clock that had already begun on the investment. And you can still pursue tax exemption or tax elimination after the 10-year holding period.
So, that’s exactly what we did. Pinnacle Partners has been able to source and present to our investor base, on an ongoing basis, a number of very attractive opportunity zone projects. So, we had another project available for consideration. And again, we provided each and every investor the opportunity to do one of two things, they could either roll over the original investment, protect those tax benefits and enjoy participation in another very attractive OZ project, or two, they can cash out. And in doing so they’d be responsible for paying the associated taxes on that investment. That’s called an inclusion event. So, we presented those options to our investors and I would tell you, I think it was 96% decided to roll over into another project and preserve those tax benefits.
There’s two other things that came with the…you can imagine the return, we generated a return from the sale. A portion of that was considered a capital gain. That happened to be a 2021 capital gain. And so that gain is treated like any other capital gain, it now has 180 days to seek an OZ investment or you could obviously pay the tax on that. So again, our investors had the opportunity and the discretion to reinvest that ’21 gain if they choose. Again, that’s a portion of the return that they enjoyed. There was a small percentage of the total proceeds that were characterized as ordinary income, and that is just taxed at ordinary rates.
So anyway, I think we might be one of the few to go round trip on an OZ investment that is capitalize, construct, and then sell based on, you know, good, compelling economics and return characteristics and yet also protect those OZ benefits by reinvesting the original gain into a new, attractive opportunity. I think this is particularly attractive in the early phases of OZ. As the program continues, I think in later instances, if you were to make a sale, say you’re eight years into your investment, that may or may not be as attractive. But we felt, all things considered, this was an extremely extraordinary return for our investors, we were doing good for the community, at the same time realizing the impact we originally had intended, and we could protect the OZ tax benefits.
Jimmy: That’s tremendous, Jeff, a lot to unpack there. First of all, you did say that this is an incredible tax benefit and you’re absolutely right. I do frequently refer to the opportunity zone incentive as the greatest tax incentive ever created. I wanna pick your brain a little bit more on that round-trip concept. I think you’re right, by the way, we were one of the first, if not the first, who has actually done what I’ve heard hypothetically talked about a lot, which is hey, what if an OZ fund sells one of the assets within the fund, what happens next? You’ve actually done it, you’ve actually helped to protect your investors’ tax status with the gain that was originally deferred, and then invested into your opportunity zone project that you then later sold. Does the 10-year clock continue to tick or does it get reset for your LPs? How does that work exactly?
Jeff: Certainly. The 10-year clock continues to tick.
Jimmy: So, if you’re already a year or 2 in, you don’t reset back to 10, you’re already down to 8 or 9 years.
Jeff: That’s correct. And then as I may have mentioned, in ’18, as you recall, the original step-up was 15%. Today, it’s 10%. Those investors in ’18 enjoyed the 15% of step-up, they retain that as well.
Jimmy: That’s important. That’s really important. You talked a little bit earlier, Jeff, about your early mover advantage, how you guys were doing opportunity zone fundraising, and some deals in 2018, even before the regs were finalized. How important was that for your firm? And what have you learned along the way because of that early mover advantage?
Jeff: Well, we got very, very clear guidance on OZ compliance, you know, substantial improvement tests, other safe harbor tests. And it was incumbent upon us to ensure we had leading expertise on the subject matter to not only guide us through the structuring of our offering, which is important but on an ongoing basis to assist us in the evaluation and in ongoing compliance of the project. So, the decision to retain OZ tax advisory support, not only at the fund formation but an ongoing evaluation of the project. So, each quarter, we are looking at evaluating OZ compliance to ensure that we are fully compliant each step of the way. So, I think that was something we decided upon early and I’m glad that we did. And then, of course, during COVID, in the enactment of the Cares Act, there were a lot of extensions and provisions. And having that counsel retained and ready allowed us to interpret those accommodations so that we could optimize, again, compliance but also, you know, serve as I said, before, kind of stewards of our investors’ investment.
Jimmy: Terrific. And clearly, you, Jeff, and your organization, Pinnacle Partners are very experienced and experts in opportunity zones at this point, in the life of the opportunity zone incentive. Let’s spend some time talking about what you have done in the past and the experience you have and how you were able to successfully accomplish this round trip OZ investment, so to speak, or recycling OZ capital. I wanted to shift gears now and look to the future with you and the new fund that you are launching, or I think you’ve just launched actually, we did a webinar on it just the other day. This is Pinnacle Partners OZ Fund VIII, it’s your first multi-asset fund, your first several funds that you had previously issued were single-asset deals. This is now a multi-asset fund. It’s a curated portfolio of multifamily opportunity zone assets. What can you tell our listeners about that particular fund and why you decided to shift from single-asset to multi-asset?
Jeff: Yeah, a very good question. So, again, our experience is an early mover, we began in ’18 with the one project we just discussed. We continued to source and ultimately capitalize seven additional projects. We’ve been very focused on supporting multifamily housing. We’ve done…in the category of multifamily, we’ve sought and partnered to deliver senior housing, workforce housing, truly affordable solutions, and what we call market rate. Within the portfolio, we even supported the first mass timber development, affordable housing development in Seattle. And, by the way, these projects are generally in the Western states. And so, we felt, number one, that multifamily was the optimum product type to pursue for OZ investing.
Second, opportunistically we were seeking any additional tax credits and programs that we could leverage in addition to OZ. And we got very fortunate with a particular partner of ours that has had two projects with historic buildings that we’re pursuing adaptive reuse. That generated historic tax credits, HTC, which can be offsetting to passiving for certain investors. So, in one case with a partner, we took an existing historic office building and we are now converting it to multifamily in an up-and-coming market in Tacoma, Washington. And then a second project is a mid-rise office building that was in need of modernization. And again, in an OZ, we can capitalize that, get the OZ benefit plus historic tax credits.
With all that said, you know, we’ve got a lot of experience to optimize the tax shield. We’ve been particularly focused on multifamily. And our investors most recently have been providing very, very significant feedback that they have appreciated our deal-by-deal approach, the institutional quality underwriting we pursue for each and every deal. And we provide all that diligence for the benefit of the investor. They wanted to retain that approach to underwriting and, in addition, obtain diversification. So they asked for a fund format, they also requested exposure into some emerging markets that have been benefiting from population migration, strong economic growth. These are cities such as Denver, Nashville to name two.
And so, what we decided to do is deliver on that request. We’ve got this highly curated portfolio of four projects, each multifamily ground up, we partnered with a leader in both OZ compliance and extensive development capability in Jill Holman and Javelin 19 Real Estate. So, together, we are sourcing the highest quality projects in those targeted cities working with blue-chip developers, and presenting that as this curated portfolio for our investors to participate in. So, we think it’s the right type of fund at the right time. It’s not a billion-dollar fund, it’s not a dozen properties, it’s very focused, not to overuse the term, highly curated, and we think it’s got the most competitive return objectives in the OZ marketplace.
Jimmy: I think it’s a compelling offer, multifamily being by far the largest asset class within the opportunity zone wrapper and probably the asset class. That’s most in-demand among investors. You mentioned Jill Holman a moment ago, I know she’s helping you with deal-sourcing and underwriting. Can you go into a little bit more detail on how she’s underwriting a lot of your deals and which target markets she likes?
Jeff: Yes, so she, you know, routine speaker at OZ conferences, quite expert on the execution of legislation. She’s been a sponsor of half a billion of projects, development projects, and some notable OZ projects. She has a great team of analysts that help with the underwriting. And so we have joined forces, that’s clear. And we are focused in Denver, Nashville, Salt Lake, Scottsdale. And we’re seeing a lot of deals and, I think you would agree, we’ve heard others applying the same that the tax benefits are compelling, you, though require a high-quality real estate project underlying any investment decision, and finding high-quality projects has been sparse, it’s challenging, and yet we’re able to derive, we think, that the best projects in those submarkets. So, great collaboration, and already we’ve got line of sight on what we call a half-look two of the four projects. And we’re really excited to be launching and have launched and now taking subscriptions before you’re in for those that seek the 10% step-up, which, you know, is expiring at year-end.
Jimmy: Right, right. I mentioned a few minutes ago through the webinar we did, Jill Holman participated on that webinar with us as well as John Shreddy at Novogradic. It was a webinar on multifamily opportunity zones strategies and essentially characterizing the strategies that your fund is deploying, Jeff. So I just wanted to let our listeners know that we are going to link to that webinar in the show notes for today’s episode, and you can find the show notes at opportunitydb.com/podcast. So, you did just mention that 10% basis step-up that benefit is expiring at year-end, and we’re very close to your end by the time this episode airs. Is the program still compelling after that benefit expires? Is it still worthwhile for investors to deploy their gains into OZs? Are they missing out on something huge if they let the end of year tick by without making their investment? What are your thoughts there?
Jeff: Well, there are three tax benefits associated with OZ investing. To use your term, you know, are they missing out on something huge? The most significant, compelling, wealth-building benefit is tax elimination. And that is obtained after the 10-year holding period, which is in full force. That, to me, is why you do an OZ deal. Now, you get a couple of other benefits that come with that. The first is deferral. So you transact, harvest a gain of some kind, short or long. A lot of people forget that you can also qualify for short-term gains, and you then qualify for deferral, and therefore you do not pay the associated capital gains tax on that gain until April 15th of 2027. So, we look at that as like an interest-free loan from the IRS to use those funds to invest in an OZ project and get, you know, a return on that investment.
The third benefit is the one that you identified here as expiring and that provides a 10% step-up. What that means, in other words, is at the time when the deferred tax is due in April 15th of ’27, you would then pay 90% of the tax, so you get a 10% step-up or 10% discount. That, to me, is nice. It’s de minimis in comparison to the other two benefits. So, you know, the program continues to be quite active attracting more and more capital to the program, for now, deferral and, most importantly, tax exemption. So, I think the program is still very, very attractive for all investors.
Jimmy: I agree. And my listeners will have to forgive me that was a bit of a softball question for you. So, I agree that the main benefit of the program is primarily that 10-year exclusion and certainly the deferral period. Although it becomes less valuable with each passing day, it’s still very valuable. I mean, at this point in time, you’re still getting essentially a five-year interest-free loan from Uncle Sam, which is nothing to sneeze at. And there is a possibility of the program potentially getting extended at some point, which may reopen up that 10% basis step-up window again, a matter of speculation at this point in time whether it gets extended or another that window reopens. For now, we can assume that it’s going to close on December 31, 2021.
But just to be very clear, because I do get these questions a lot, gains that are eligible for deferral into opportunity zone investments carry out all the way through the end of 2026. So you can have a gain as late as the end of the year 2026 and that gain would still be eligible for that final benefit, that 10-year benefit, as long as you get it invested within 180 days of that event. So about the middle of 2027 is really kind of your last chance to invest in opportunity zones and an asterisk there actually, if you realize the gain through a partnership, Schedule K1, you actually have a little bit more time even, I think it’s close to mid-September 2027 is the real drop-dead date. All that is to say, without getting too technical, is that there are still many, many years remaining on this great tax incentive program, despite the fact that one of the benefits is expiring at the end of this year. Jeff, anything else to add there, or did I cover all right for you?
Jeff: You covered it completely. Thank you.
Jimmy: Excellent. Jeff, it’s been a pleasure catching up with you again today and to speak with you. Before you go, where can our listeners go to learn more about you and Pinnacle Partners?
Jeff: Yes, well, come to our website, www.pinnacleoz.com. And you can see details on the OZ fund. It is available for subscription before year-end and continuing through 2022, likely closing the second quarter of ’22.
Jimmy: Terrific. That’s pinnacleoz.com. And for our listeners out there, as always, and as I just mentioned a minute ago, I will have show notes for today’s episode on the Opportunity Zones Database website, you can find those show notes at opportunitydb.com/podcast. And there you’ll find links to all of the resources that Jeff and I discussed on today’s show. I’ll be sure to link to pinnacleoz.com as well as the webinar about the new fund launch of Pinnacle Partners OZ Fund VIII that I discussed a few moments ago. Jeff, a pleasure as always. Thanks for joining me today.
Jeff: Well, thank you, Jimmy, always enjoy speaking with you.