A Lifetime Unraveling the Worst Tangles in the Tax Code

Jack: Welcome back everyone to The OZExpo Podcast. I am your host Jack Heald. And joining me today is Michael Sanders, who's the senior tax partner at the Washington office of Blank Rome. Michael, welcome to The OZExpo Podcast.

Michael: Thank you. Look forward to it.

Jack: Give us the 30,000-foot overview of Blank Rome in general and your work there in particular.

Michael: Blank Rome is a national – actually international – law firm. We have large offices in Philadelphia, New York, Washington, Los Angeles, even have an office in Shanghai, Pittsburgh, Houston, Chicago now. And I would say, diverse practice in every area in the practice of law.

The area that I specialize in and focus on in throughout the country is tax from the partnership and corporate. I do a lot of 501c3. I have a major practice in the tax credit field, low income housing, New Market Tax Credits. I've done over a billion dollars of representation. Historic Tax and Opportunity Zone funds become a major portion of the practice.

We also do a lot of joint venture work for nonprofits and I have a text, a treatise, Joint Ventures Involving Tax Exempts published by John Wiley. It's in fourth edition.

Finally I've been teaching at Georgetown and GW Law Schools for four decades. But I'm a deal lawyer. I represent for-profits and nonprofits in transactions.

Jack: Very good. I would like to make sure I read something right. As I understand it, your treatise was cited by the Supreme Court in one of their fairly significant decisions involving Hobby Lobby. Is that correct?

Michael: Correct. They cited a passage in my text which frankly it's hard to figure out how they got to it. I don't believe it was in either of the briefs filed. But they cited it talking about joint ventures – the kinds of structures where for-profits actually doing charitable tax work. So it was, it was a very good feeling.

Jack: I could imagine.

Michael: Yeah. Unexpected.

Jack: I want to ask you a question that's strictly for my own edification because I keep running into this and I keep forgetting to ask anybody who would actually know what it really is. You talked about the historic, what is it? The HTC?

Michael: Historic Tax Credit.

Jack: Yeah. I don't know what that is. I see it pretty regularly. I have no idea what that is.

Michael: Well, it’s a somewhat complicated provision. For certain properties located in the historic district that are going to be preserved by the developer, there is a 20 percent tax credit that's available to the developer. And often the developer enters into a master lease agreement and transfers a credit to a master lessee. But 20 percent credit, based upon the QREs it's called, which are certain types of the dollars that are re-invested in the redevelopment that qualify.

It's a very attractive provision, but you've got to go through various steps with approvals in order to get the project and the historic redevelopment approved in advance from the Department of the Interior in advance in order to take advantage of the credits. So it's an incentive for preservation of older buildings.

Jack: Okay. I hadn't intended to ask you this, but since we're talking about Opportunity Zones, I'll do it. Is there overlap, is there a way to layer the Historic Tax Credit with an Opportunity Zone investment or development?

Michael: Yes, yes, absolutely. You can actually layer not just that New Market Tax credit, potentially the low-income housing tax credit, and the historic with Opportunity Zone benefits. With Opportunity Zone, doesn't provide a tax credit. You've got a different type of very substantial deferral and exclusion, she can combine, unite with the other tax credits.

Jack: Oh, well I can't imagine that I haven't run into anybody so far who has pointed that out, but maybe I just haven't asked the question appropriately. Okay. Let me make sure I've got that. So, you can combine the New Market Tax Credit, the Historic Tax Credit, assuming you got the right kind of property and is there a third tax credit or was it the Opportunity Zone?

Michael: Low Income Housing Tax Credit housing. Yeah. But they all in each one they have to be done very carefully because they all have their own set of rules. And you have to walk a tight rope in structuring because for example, one of the real attractions to the Opportunity Zone is the exclusion after 10 years. You sell your interest, exclude the appreciation from tax. Well, one of the sensitive issues in low-income housing area is that the property may well not appreciate after 10 years. Each one of these has different technical issues that have to be met.

Jack: But theoretically you could layer all of those to increase the return on your investment.

Michael: Exactly. Yes.

Jack: That point definitely means get yourself a good tax attorney and a good tax accountant. Okay.

Michael: I would say, and by the way, good tax accountants, very important, one that knows the area, because with any of these structures that need to see projections or forecasts.

Jack: Right. Well that takes me to probably the meat of the question I want to talk to you about. We had the second tranche of regulations come out in April. It closed a lot of the open questions, but I know there are more open questions that still should be addressed. What are some of those significant open questions and what are your thoughts in regard to them?

Michael: Well, let me just say yes, the second tranche answered a lot of questions, but it also opened up many more and the brighter the tax lawyer – many tax lawyers, I'm convinced they're brilliant – the brighter they are, the more issues they see. And the problem with that is that client, which is typically the real estate developer or the private office, they're just trying to figure out how they can move forward. And with all these other additional issues on the table, it makes it somewhat difficult for the, let's say, conservative investor to make decisions. We don't expect to see another set, another tranche of regulations. They'll probably finalize them after hearings and written comments. So for the time being, we've got to deal with where we are today with the cards that have been dealt.

So, what I can do is sort of outline a number of issues that are on the table. And what I try to do for my clients is say, “okay, we're not going to wait for perfect answer. As long as you are in good faith, we're going to move forward and we'll be able to close deals because the sooner we get in there the better we're going to be in fact, because property located in designated Opportunity Zones has been picked over and you want to close your deals because otherwise, you're not going to truly have an opportunity.”

So, let me hit four or five and show you how we're advising clients to move forward. As far as eligible gains, like you need to have what they call an eligible gain. The regulations define eligible gain as capital gain long and short term, and short terms gains advantageous because you’re going to be taxed at ordinary income.

So you certainly want to take dollars equal to those gains and invest them as an equity investor in an Opportunity Zone fund. And there, the language says “from actual or deed sale or exchange or any other games that's required to be included in the taxpayer’s computation of capital gain.” So, you have to look in the partnership context at K1s. And there's a line of unrecaptured 1250 gain which follows depreciation recapture.

And I believe those unrecaptured 1250 gain is taxed at a maximum of 25 percent maximum capital gain rate that that will be counted as eligible gains. And that's an important issue.

Sort of tied into that is this section 1231 gain. What they did in this tranche created a potential serious problem. They require investors to net and that probably means the partner, not the partnership. They have to net their 1231 gains against their losses.

There's only the net gain will qualify and they're telling you in the regulations that this determination has to be made on the last day of the taxable year. Basically they're putting you in the penalty box. Problem with that is if you have to wait to the last day of the tax year, let's say I have a transaction I close in April. I can't invest. There's 180 days to invest.

I can't reinvest until the last day of the taxable year. And it's even more complicated because you're not going to know if you have met capital gains until you get all your K1s from the different partnerships as well as your personal transactions. So you might not get them until the following April, May. We have 180 days room.

So the reinvestment may be stalled and you don't have optionality in the regulations today. So this is a potential issue. And we're trying to figure out how to get around it.

One approach is not to follow the regulations, that does have risks in itself.

Jack: And this is just on the 1231 gains?

Michael: 1231 gains, yes. You know, shopping center, 1231 gains.

So let me talk about another subject. Initially from the regulations, there's inconsistency in the treatment of gain after 10 years. And that's important because one of the major advantages of the Opportunity Zone rules is you have an exclusion of any appreciation if you sell after 10 years. So what the regulations say is that if an investor sells his interest in a Qualified Opportunity Fund – a QOF – as taxed as a partnership for example, and makes the basis fair market value basis election on its sale of its interest in the fund after 10 years gain is excluded. This is terrific news. So even if the investor has used net losses due to depreciation over the 10 year period and may have received leverage distributions from the QOF over the 10 year period, this is a great result.

But if the QOF sells assets, then the way the language is drafted in that case get potentially a different result. You can exclude the capital gain, but you've got to look at the K1 that you received, assuming that the investor held his interest for 10 years. And this applies only to capital gain allocated and not to amounts that are characterized as ordinary income such as depreciation recapture. So you get a different result. And then finally, if in most cases, you know the QOF is investing these dollars in next year - a QOZB in an LLC for example - and that entity sells assets, the beneficial rules of exclusion don't technically apply to gain recognized at a QOZB. I don't know if this was intentional. It appears to be, and it really is an issue. So, you've got to work closely with your tax lawyer in structure.

Jack:    Let me make sure I understand. So, as an investor, I've got my money in a Qualified Opportunity Zone business. If the business sells assets, any gain on those assets is not included in the exclusion?

Michael: Today, typically what you do is you invest in a fund, the QOF. The fund drops the dollars into another tier, lower tier. And I'm going to explain a little later why that's attractive. And if that lower tier sells assets, you don't today – based upon the regulation – get the benefit of the exclusion. So that's the issue. And that's the technical issue that needs to be resolved and I am hoping that Treasury understands that.

Jack: Yeah.

Michael: Yeah.

Jack: I've heard that one.

Michael: Yup. And another one for planning purposes, comparing 1031 like-kind exchanges with Opportunity Zone tax benefits. Opportunity Zone property investments are not restricted as to real estate as a 1031 is since the 2017 act. It’s available to businesses, hedge funds and so on. Section 1031 deferral can be permanent basis step up at death. While Opportunity Zone allows permanent spaces step up without the need to die if you hold for 10 years. Also, Opportunity Zone option is available to what we'll call a busted 1031 transaction.

An Opportunity Zone in fact can do a 1031 rollover. You know, it's basically years down the road, but it may be issues because it has to meet a substantial improvement test in many cases.

There are also another set of issues. Advantages in these new regulations for leasing properties by related parties. The leased tangible property must be acquired under lease after December 31, 2017. But the good news is the leased property does not need to meet the original use or substantial improvement requirements. It must be a market rate lease. If it relates to related parties, further limitations, no prepayments are allowed for more than a 12 month period and the full term of the lease is too long, in that it exceeds the useful life of the building, it can be considered a purchase under tax rules, thereby triggering substantial improvement tests in order for the property to be QOZP qualifying property.

And it could be treated as a sale between related parties and to that extent fail – not qualify – for the 70 percent test, it would be treated as non-QOZP property. Technical rules!

But want to add one other final points in this area. The longer the term of the lease, the greater the value of the property and the more potential appreciation that may be excluded from sale, from tax on sale after the 10-year holds. Further good news, any improvements made via lessee to leased tangible property should satisfy the original use test. So that's good and the improvements will revert to the leaser at the end of the lease term.

A few more points. Active business? The regulations provide that leasing real property used in a trade or business is treated as the act of conduct of a trade or business. But stipulate the merely entering into a triple net lease is not considered an active trader business. These words “merely,” and so this is a real problem because many industrial leases are triple net. So you need additional leasing activity so that it can rise above merely a triple net lease scenario. So you need advertising, management, operations. In the new markets tax credit area, gross income within three years is favorable relative to business. We don't have that here.

And there is language, if you look back at the OZ regulations language of what is “meaningful participation”, is an IRS notice 2006-77 which is helpful.

One point I want to make on unimproved vacant land, first of all tangible property really turns on when the depreciation or amortization begins to determine when first placed in service and the regulations…

Jack:    Sorry, I missed that last, I missed that last sentence. Determines what?

Michael: Oh, when placed in service.

Jack: Okay.

Michael: Original use, in other words, if it's original use, you don't have to do substantial improvement to the property.

Jack: Right.

Michael: Problem is that the regulations have you evaluating on an asset-by-asset basis and not in the aggregate, which presents a problem, especially when you have a business with a lot of tangible assets. Maybe difficult to meet the substantial improvement test. There is a beneficial provision that if property has been unused for an uninterrupted period of five years, it will be considered original use, which is beneficial by either the QOF or the QOZB.

We practitioners wanted one year, they said five years. But there's another interesting point here. There's concern about the potential with use with land banking. In other words, if your way for a taxpayer to buy up a lot of land. There's language that says that if there's the expectation, intention or view not to improve the land by more than an insubstantial amount in 30 months, it will not qualify.

There's no definition of insubstantial for this purpose. So that's another concern. Land banking doesn't work.

And the final area that I want to comment on has to do with the advantages of the two-tier structure. That is using the QOZB. LLC, partnership, corporation as second-tier, lower level. It may be advantageous for a QOF to invest through a second tier, provided it is not as disregarded entity, has to be more than one member of the corporation to get the benefit of a 63 percent qualifying asset rule as compared to 90 percent at the QOF tier. And unless you take advantage of 31-month safe harbor, which is a real advantage.

And then these regulations, they allow this working the capital rules to include the development of the trade or business as well as the acquisition, construction, and substantial improvement of tangible properties. So, it covers payroll, inventory, occupancy and so on.

And they said further that the 31-month period does not violate the safe harbor if the delay is due to waiting for government action which is not completed during the 31-month period. And finally the regulations provide clarity that a business may benefit from multiple overlapping or sequential applications of the working capital safe harbor.

So those are some of the issues that I see and I just wanted to summarize them for you and your audience.

Jack: That is an outstanding set of summaries. I'm glad we're going to have a written transcript of podcast because that's some really good stuff there. I wanted to circle back around to because you quoted a 53 percent requirement.

Michael: No, that I did that was not 53. 63.

Jack: 63. And what does that apply to? That's the first time I've heard that number.

Michael: Yeah. Well, at lower tier, all you need to have in effect is 63 percent of the qualifying assets in order to compare it. Normally it's 90 percent at the QOF level and they dropped 90 percent of the dollars down into a QOZB to 70 percent.

Jack: Ah, OK. Gotcha. Alright, that makes sense. I just hadn't done the math before. I just had the 70 percent and the 90 percent and it never occurred to me. That's what that added up to. Yeah.

That is probably the most information-dense 30 minutes that we've had on the show maybe ever. And I love it. Thank you. Thank you so much.

Michael: Sure.

Jack: I want to take the conversation in a slightly different direction to find out a little bit more about Michael Sanders outside of the Opportunity Zone stuff. Tell us about your work prior to coming to Blank Rome. When I look at your biography, it looks like you've done some pretty interesting things.

Michael: Well, first of all, I've been on the board of many charities. And I've been also counsel to Enterprise Community Partners. Jim Rouse had developed Fanuel Hall, Columbia, Maryland, a major developer, Baltimore. I helped him when he retired from the Rouse Company structure. Many decades ago, the Enterprise Community Partners, which is the major low-income housing 501c3 in the country. In my career I started Justice Department Tax Division, and the first case I was given as a litigator in government is the founding church of Scientology.

Jack: Get out of town! Oh!

Michael: And that's how I got into the 501c3 area. I've been teaching for decades at Georgetown Law School, graduate tax. But that's how it started when I first got into the 501c3 subjects through the Scientologist case.

Jack: I’ll be darned.

Michael: Yup. Started there. And early in my career I represented the Ford Foundation. I even represented the Kennedy family for a ruling on a ruling issue with the IRS. So, I've been involved in a lot of interesting and in partnership tax and structuring and tax shelter issues throughout my career.

Jack: I would love to have another podcast just on your work at Treasury, starting with the Church of Scientology. That's fascinating stuff.

Well, Michael, this has been a great conversation. Before we sign off, I would like to give you an opportunity for last words. Any other things you'd like to leave our listeners with.

Michael: Yeah, I guess I'm going to really reiterate a point I made earlier. The audience shouldn't sit back and wait for perfection. And they also shouldn't be overwhelmed by the brilliance of tax lawyers who can totally confuse you on structuring. You've got to make some decisions to move forward, and as long as you're in good faith and you're not trying to game the system, I'm very optimistic that you will be successful. And that's what I would suggest.

Jack: Well, Michael, how do folks get ahold of you or Blank Rome if they would like to have more information?

Michael: My email address, Sanders@blankrome.com, my number (202) 772-5808. Delighted to talk.

Jack: Awesome. And I want to remind our listeners that as always, this contact information for our guests is available on the OZExpo Podcast website. And I guess that'll do it for today.

I'm Jack Heald with the OZExpo Podcast and for Michael Sanders.

Thanks for joining us. Let me remind you to click on that subscribe button so you get updated anytime we issue a new episode and we will talk to you, next time.

Michael: Thank you Jack.

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