Joseph Darby
The Opportunity Zone Expo Podcast
Harvard-Educated Sportswriter-turned-OZ Tax Wizard Gives Guidance with Levity
Transcription
Jack: Welcome back everybody to the OZExpo Podcast. I'm your host Jack Heald. Joining me today is lawyer/attorney Jay Darby from the law firm of Sullivan Law out of Boston. Jay, welcome.
Jay: Oh, thank you, Jack. Thanks for having me on the podcast. Very excited to be here at Las Vegas for the Opportunity Zone Expo. And to be on this podcast.
Jack: We're giggling because we've already been talking for about 10 minutes before I turned to the recorder on. So, we're gonna just jump right into it. So, I'm just rewind for us. You took a math degree at the University of Illinois and then for some reason decided that that being a mathematician wasn't in the star in the cards for you.
Jay: No, in those days, it was back out so long ago that back in those days, math was sort of its own esoteric area. People couldn't figure out what you do with it in the real world. So, I ended up going to law school and about five or 10 years later, they learn to use math to all kinds of complicated options trading and synthetic derivatives
Jay: And, if had been 10 years behind in terms of the timing of my math degree, I probably would have been wealthier and happier, well wealthier anyway. And I am today. I'm pretty happy actually. I like practicing tax law.
Jack: So why law and for that matter, why tax law?
Jay: Well, I had a math background and I told you in the first round, I got out of law school and I was very young. I was 24. I couldn’t imagine being anything as dull and boring as an attorney. I became a sportswriter for five years and covered all kinds of sports in the Boston area.
Jack: That was in Boston. Okay.
Jay: Yeah, it was for the Boston. A real paper back then existed. The Phoenix existed back and I eventually wrote for a United Airlines inflight magazine and number of articles over the years.
Jack: So, we've already talked about this, but I'd just going to touch on it. Your favorite interview ever was?
Jay: Where I went with, I was, I was covering the Boston Red Sox in 1988 and their manager, Joe Morgan had just been promoted. They'd fired the prior manager end made him the interim manager. He went on a winning streak. They won about 20 out of 21 games or something. And I was supposed to interview him at the end of the game on a Saturday and he said, it's just been a long crazy day. They had this extra inning, and he said, can you come back tomorrow morning? I'll give you all the time you want to come back at 9:00 a.m.. So I went back to his office on a Sunday morning at 9 and walked in and it was Joe Morgan and Peter Gammons, who are probably the two best known sports writers on baseball in the entire 20th century.
Jay: The really the top two people it was the two of them, me listening, talking to Jim Morgan about baseball and Morgan had been a great baseball player in his sixties. He managed the minors. He'd been through it all. And why the most amazing conversations I've ever, maybe the most amazing conversation with baseball I ever heard in my life.
Jack: There's hardly anybody better I think to talk about baseball.
Jay: It was wonderful.
Jack: Okay. So, I'm going to treat you like the Joe Morgan of tax loss. So you end up as a tax attorney. That sounds like that would've been an interesting change of pace there to go from baseball to tax law.
Jay: It did. Well, there's a lot of numbers in baseball and I, thought, I'd been out of law school for five years and I had this a law degree from Harvard law school and it was like a black hole, had this required a huge amount of gravitational pull.
Jack: When did you sit for the bar? Was that before or after baseball?
Jay: Right after law school. While I still remembered stuff.
Jack: Okay.
Jay: So, I passed the bar and then spent the next five years, not practicing.
Jack: So, you were a sportswriter with a JD. I love it.
Jay: Yeah. It was pretty interesting.
Jack: From Harvard, no less. Did you get notes from Harvard saying, could you not talk about this?
Jay: No, I, it actually helped [that] it had nothing to do with sports writing. He would get people's attention and they want to come in and say, what the heck are you doing? Who are you, you know, so I get opportunities to, you know, get in the door and once you're in the door, if you talk fast, it's hard to get you out. So I was like a bad relative I was hard to get rid of.
Jack: Okay. So, let's talk about, let's talk about the Opportunity Zone.
Jay: Great.
Jack: You are a tax lawyer. Talk. We'll start general and we'll just drill down deeper and deeper.
Jay: Yeah. We came into the Tax Cuts and Jobs Act and enter 2017 when it was passed an existing law. There's kind of folded in at the last minute. Nobody had paid attention to it. Nobody paid attention even after it was enacted at first. They had a huge amount of mass. I described it as a, an iceberg and had a low visibility, but a huge amount of importance in mass. It took a couple months kind to say, Gee, what is this? I've worked on it almost continuously since it was enacted.
And it is unquestionably one of the most complicated, if not the most complicated area of, of U.S. Tax practice. I've dealt with all the other complicated things that the guilty regime has been putting in place. And the QBI deductions that are very complicated, this tops them all, even in bond pracs in other areas that are notoriously complicated and idiosyncratic.
This, I think is the most difficult area of tax law because of the combination of complicated concepts being integrated. And until recently, the lack of guidance. We just didn't know the answers to questions that we had to be able to answer in order to do deals. And that's why it's been kind of slow to get off the runway in a lot of ways.
Jack: Um, no. An awful lot of folks come on the show and talk about real estate now, which is great cause it's seems to be at least the low hanging fruit for Opportunity Zone, work. But you want to talk about the ongoing business side. So, let's do that. Probably the first question I want to ask you has to do with the updated guidance that came out in April. Apparently, we got some updates about leasing rules. How has the leasing of tangible property been clarified and what do we need to know about that?
Jay: Let me, that's a great question. Let me just step back and set the sort of table and then talk about that question. I always thought from the very beginning that the Opportunity Zone tax incentives are all about startup companies. Yeah. IPO's a new companies growing and exploding and value. What happens is it excludes all the gain on an investment. In real estate, if you have a good investment it will typically double every 10 years. If it's a good investment, it triples in value.
If it goes up by a factor of four, everybody calls it a home run. Well, I mean, you look at it like a Netflix or an Amazon or a, you know, name your Google name any sort of high tech startup. They don't go up two times.
They go up 100 times, you know, and so instead of a homerun and circling the bases, you get to just keep running around in circles as long as you want. Basically with that kind of investment and the idea of being able to exclude a hundred times or 25x or whatever it is. So, I mean this was always made to be for, you know, venture capitalists or private equity investors, much more so than real estate just because the upside is what it's all about and the upside is so much greater on a multiple basis compared to your investment then now.
Jack: I'm really glad to hear you say that. I really am.
Jay: Yeah. So I think that this was always meant to be a business incentive. The thing we had a hard time figuring out is how do you connect the business to the Opportunity Zone and the real estate. It's obviously real estate oriented, geographically oriented into these census tracks. And the rules weren't clear enough. We just didn't know the answers to the questions. The most important of which was the one you just posed, which was about leasing. They have a rule that said, substantially all which they conveniently developed said was 70%. The IRS is extremely good at translating phrases into percentages. It's one of the important parts of all tax regulations. And they said substantially all could have been anywhere from 70 up to maybe 90% they came in at the very low end, which is helpful at 70% but it said substantially all of the property, tangible property owned or leased, had to be qualified property and qualified property had to be purchased. So you had this sense of lease property is in the denominator of our 70% calculation, but not the numerator and that we had no idea.
And how do you value a lease? I mean a lease is a liability is not really an asset. You know, you've gotta pay to use the property. And so at the very least it's got an offsetting liability. So all kinds of questions that really sort of paralyzes from able to really move forward. We had a question, can we go into an Opportunity Zone and lease the property, which is what every business wanted to do. We hope that was the case. But these leasing rules seem to indicate that that wasn't a good idea or wasn't possible. And then there, the related question is if we can't do that do, we have to buy real estate and substantially improve it.
No business wants to spend all their other scarce capital on buying, improving property. They want to, they would improve their software or their services or whatever, their product and services in the business area.
So, all that pointed to the fact that we had to have a clear answer on how leases were dealt with. The first set of regulations which came out in October 2018 didn't answer that question. They gave us the 70% number. It didn't say 70% of what, it's literally, you know, times what can, and we need a multiple canned as it's called in mathematics.
And the result was that we were looking for as an answer to that, which came out in April. You know a few weeks ago and it was spectacularly positive. What they said was that a lease property could also count as good property. We were hoping, they'd say...
Jack: Thank you. I have, I've been trying to understand that. I get it now. Carry on. This is good.
Jay: Yeah. So you purchase properties, good lease properties also good. And so first of all it goes into the numerator as well as the denominator. So instead of being just a negative, we were so worried about it. We just hope that they come out and say lease property has zero value because you've got to pay fair market value for it. So it doesn't really have a lot of built in value. We just didn't want to have a bad number in the denominator.
Jack: Right.
Jay: Probably reverting to my mathematical background.
Jack: Yes, I've noticed that.
Jay: It's all about the math. It really is. I mean, you've got to get 70% and we said zero is good enough. As long as it's not a bad asset, we can figure out how to make it work. But he said there's no, no, it's a good asset.
It goes into the, the numerator, not only that, but they came out with a valuation methodology that's extraordinarily favorable. You take all your lease payments and you, and you discount them in a present value using an extremely low interest rate, which is very pro taxpayer. It means not only do you get to count it as a numerator number, you get to counter as a big number. They're treating you as if your credit worthiness is the same as the U.S treasury.
And so that all the payments get effectively. Yeah. Present value at a much higher number than probably your own personal rate would suggest. And so, the result is that we went from, how are we going to meet the substantially test for tangible property to a point where it's almost the other others, reverse. It's almost like how are you going to fail this unless you screw up cause you're going to have to be in O-Zone leasing property to a business. And once you do that, at least count, so much as good numbers in the numerator. You really would have to have to make mistakes with your handling of other tangible property, they ended up missing the 70% threshold in most cases. So it went from, “we don't know how to do this” to, “we're set, let's get going.”
Jack: That's the best explanation I've heard so far. You know, my two boys, we've been talking about doing some investing together and one them is a financial analyst and the other one is just a hardcore geek. And they just pepper me with these questions. You know, how do we do this? What are we doing? Those are really good questions. If we were buying a piece of property, I think I understand, but, um, when it comes to actually creating a business and building a business in an Opportunity Zone, I hadn't understood. So let's see. I guess we've talked about leasing, oh, well, leasing from a related party. Oh yeah. Another question that has come up.
Jay: Yeah, I mean, I mean there were a whole bunch of absolute critical questions, all of which got answered in the leasing area very favorably. As you said, the first is, can I go into an opportunity zone and just lease the property and use my money to buy my own business? The answer is yes. The second thing was how do I value the lease the answers very favorably and it goes into the numerator. The third thing is, can I have a lease from a related party?
And that was a real sticking point because lots of people actually have property in an Opportunity Zone that predates 2018 and so it doesn't qualify as good property and so they sort of wrestle with it. And they were quite all kinds of fairly convoluted suits, suggestions of your sell it to a partnership that you own less than 20% of the, so it's not a related party and all these kind of ways to contribute to or, or it's a bad asset that just contributed in the solution, which is simple, elegant and fabulous for deals going forward is you can lease it to yourself even if it's a related party, it counts as a bonafide lease, as long as it's at fair market value.
And it's got a couple other protections that are designed to prevent it from being abused. but the bottom line is that related party leases make it possible to create a structure where you don't give up the property, which most people didn't want to.
Jack: Right.
Jay: A, you get to put it into a business, on a lease basis that counts as a good asset for the lessee and, you're off and running. So, I think all of that combination of a leasing changes is probably the three biggest changes affecting the ability to create and grow businesses in an Opportunity Zone.
Jack: This was in the 168-page guidance that came out in April.
Jay: It was.
Jack: I started to read it and I said, there's somebody there, there'll be somebody who will explain this to me so I don't have to.
Jay: Yeah, it's a long dance law. It's very hard. I pulled out a 21 questions, which I'm happy to make available to participants in the Opportunity Zone Expo.
Jack: Is that going to be something that, um, we could make available online?
Jay: I think so, I'll follow up with you and we'll, we'll, we'll see.
Jack: Okay.
Jay: I picked 21 questions cause it's actually a dating game for kids these days. Yeah. You ask 21 questions is sort of a millennial dating game and I figured that it was time to go on a date with the OZ regs because we really needed to get to know it a whole lot better. It wasn't so easy. If we asked 21 questions to the regulations. Maybe we'll get some good answers. I've actually run in…
Jack: I've actual run into that, that 21 questions. So yeah, we're not gonna do that. Okay. Before the show we were talking about something that just made my head hurt. I have a high degree of confidence that you're going to relieve my headache here. How are section 1231 gains treated for the purposes of investing an eligible gain. Oh, into a Qualified Opportunity Fund.
Jay: Uh, well that's one of those ones where we got an answer that had the benefits of clarity but maybe not the benefits of functionality.
Jack: Yeah.
Jay: Cause we know that this law was one many, many things that made it a complicated and difficult as it was not especially well drafted. They originally started off saying any sale of property gain for any sale of properties eligible. The first set of guidance back in October, 2018 and said, no, no, it's gotta be capital gain. Okay. And then the answer was, well, you can get capital gains from selling a capital asset, but you also get capital gain from selling a 1231 asset, which is an asset used in a trade or business, for depreciation and held for more than one year. And let me just tell you there's a ton of 1231 assets in this world.
If you walk into Costco, everything you see except for the people either inventory or property used in a trade or business, you know, there's everything there is, is depreciable property, that you can sell and if it sells at a gain, you get the capital gain if it sells a loss, ordinary loss troubles at 1231 has this netting rule of losses against gains to come up to the net amount, which is really the big capital gain or ordinary loss. We just didn't know if you could isolate out one piece of property.
The IRS unfortunately said you cannot take one piece of property, recognize the gain for 1231 purposes and call that capital gain because 1231 is all about the netting and they felt they had to have maintained some fealty to the netting concept and to net it you had to be at the end of the year.
So, they came over the rule that logically makes sense in the IRS has perspective. You take 1231 gain, you net at the end of the year, wherever the net amount is, if it's positive, you got 180 days from December 31 to invest but as you and I chatted, but beforehand I got people selling in real deals, in real time selling companies. And what they'll do is they'll sell a business.
They'll have the gain, they'd like to roll it over to the next business, which is the kind of thing in an Opportunity Zone. All the things, the act is trying to promote. The trouble is that they'll have gain from capital assets, which can be invested from the day that the gain occurs. But they'll also have 1231 gain might have a lot of it. In the case of riff, it's, I've got real estate component to the business or you know, it was a substantially a real estate business.
You'll have this split between the investment 180-day date, starting for the capital gains in the day it's sold versus the 1231 which doesn't start until December 31. Example I gave, if you sell a business on February 1st okay, you may have capital gain that you've got 180 days to invest. So, you got to get ahead and invest by you know, something one of the magnitude of August 1st you know, 180 days later. But the 1231 gain, you can't even be, you begin to invest until December 31.
So, the same transactional event will create two paths of gain. We've had discussions that people that are actively involved in kind of dealing with the IRS. And we've already said we've got to go back and have some effort to try and change that so it can match up. When you sell a business, then you get gain out of it. You want to be able to roll it over all is one opportunity, you know, a reinvestment into an Opportunity Zone investment at that point in time.
Jack: Now, as I did my research, it seems like you have been involved with the government, at least in an advisory role, about how we need to interpret these things and how it needs to be clarified for those of us on the investment side. Tell us a little bit about that.
Jay: I'd be delighted to. I've been fortunate. I was involved by the Real Estate Round Table in Washington, which is one of the maybe the premier, a group representing the real estate industry in Washington on Capitol Hill. We got pulled into a service select group of people to interface first of all with the Real Estate Round Tables collection of people to come up with good policy ideas and then go in an interface with the, IRS, the Treasury and the people that Joint Committee on Taxation who represent the congress. And we've gone in several meetings and presented, both written materials and then followed up with face to face meetings and just explain what we think are reasonable, ways to interpret the rules and the laws. I'm happy to say that many of the things we've proposed were accepted.
We weren't the only people proposing some of the good ideas. There were others, but we were certainly one of the central groups that were helping shape the IRS's response in pragmatic ways. And we think that the second set of guidance in particular was excellent work on the part of Treasury. There’re things that we, got, I'll, this is, we didn't get. We listed Treasuries reasons for all their decisions. And we'll go back with a few more examples. Like I said, with the 1231, we got of have a kind of an ability to make, make it integrate with when sale of a business can generate, you know, two different streams of money, more than 180 days apart. So, if I was just one simple example, but it's been, it's been a real pleasure to be involved with the people at the very high ends of an American tax practice. And, at the IRS and the Treasury there, they've done an excellent job at the Treasury of interpreting very hard law and doing a great job and you know, Mike Novi and, Dan Coyle skin, those people who've done a superb job of playing the government's role in this whole process.
Jack: You know, you're not the first person I've heard say that. As just kind of your generic run of the mill taxpayer, my perception of the IRS and Treasury is not positive. I've heard a lot of folks say very positive things about how this particular part of the act was administered. Obviously, some claims, some complaints about the fact that it was a little confusing and possibly thrown in at the last minute. But in terms of the government's response after the fact, it's been very positive. Is that unusual in your experience?
Jay: I don't think it is, although I think that in this particular area there's been a real convergence of effort to make a complicated but extremely well-intentioned law functional so we can accomplish the goals that we've set out to do. It started with a senator Tim Scott, who was that was the original person advocating and supporting the bill. He managed to reach across the aisle, which to his credit and to everybody's credit is hard to do these days given how divided and polarized Washington is. He got to Cory Booker to cosponsor the law. Tim Scott did it because he really cared. He really wanted to see money going into, you know, underserved, underinvested areas of the country and really help people out, which it, by the way it has done it.
But my understanding is that Opportunity Zones, have appreciated about 20% on average across the country, since the law was enacted as the value proposition's already gone up. But lots of things are going into these areas in positive ways. The IRS, and the Treasury folks who've tried to implement it in a way that's consistent with the code, but also faithful to the goal of trying to promote investments in these Opportunity Zones. They've been criticized.
They've said it's going to lead to gentrification and all kinds of things. But you know, I think a lot of people said, no, it's going to lead to jobs in areas that need jobs and businesses going in. It's not just a, I mean we talked about maybe the high tech business. You've got a software company, brand new software company in an Opportunity Zone. But those people also want to have Dunkin Donuts and CVS and all the other kinds of things that go with it. So, it brings with it the other aspects of things that are needed in those areas. I mean there's nothing like having a CVS drug store or a coffee shop in a place that doesn't have either of those things. I can tell you I need the coffee more than the drugs. I need both, over time.
Jack: I was talking with Erin Gillespie who was involved with the creation of the Florida Opportunity Zones. And she told me a couple of stories about individual communities in Florida that had done just some amazing things. Successes, a really cool situation, very creative. There wasn't anything Opportunity Zone specific about this particular activity. What this community did was they bought a piece of property that was, I think essentially abandoned. They refurbished it, and turned it into a lounge for the local cops, stocked it with soft drinks and food and just made it available for the cops to come by. And so, it was a high crime area, you know, very unappealing in terms of investment. And by taking this building that somebody had that was not going to be used for anything else. They basically turned it into a satellite police station, constant police presence and that all by itself, you know, helped to reduce crime. And I just thought it was an extraordinary, a solution to kind of a gnarly problem. I want to get that out there because I think that's the kind of thing that when folks are looking at these high crime areas, how do we solve that particular problem? That's not necessarily a financial problem. There's more to it than, than just investment.
Jay: So yeah, Erin is a hot ticket. She and I worked together and in some areas that I've been trying to get actively involved in what are called a P3, public-private partnerships. One of the terrible problems right now with the law is that it's driven by entrepreneurs. And I think that the logic of it is good. There are tons of tax incentives to try and help areas. There's a New Markets Credits and Empowerment zones and Go Zones and all kinds of different things they've tried to do. And they always end up being kind of bureaucratic and difficult to administer and people just say it isn't worth the hassle to deal with the government to get near the incentives. This is really just saying we're going to use taxes and have entrepreneurship go in and, and drive the bus.
And I think it's probably the most likely way to get a lot of energy and a lot of change. the trouble is that involves entrepreneurs making private profit. The cities and towns just don't kind of instinctively do well in giving land to someone to turn a profit that they're not part of.
We're trying to come up with good ideas for a 501C3s or for cities and towns, to come up with a partnership, a strategy where they are putting in land in a partnership expecting to make a profit. They may, there's a lot of criticism that comes with that in this day and age. If you're a political person who is sort of turning money over to someone's going to turn a profit. But it also turns it over to people that are likely to run it better than it might be run if it's a public utility.
I'm not gonna be too critical of public utilities or publicly-managed, activities. But we all have a sense that entrepreneurship with the energy and the drive can produce, a qualitative improvement. So, trying to make those work is a challenge.
I've, I've talked to, a 501c3 organization, a major university, about literally doing their own PPM, doing a private offering, and they've got a piece of real estate they'd like to have developed in an Opportunity Zone. And I said, own it. You know, just bring in investors and an entrepreneur to manage it, to build a project in turn it into dynamic area and just go into business yourself. They almost had a heart attack.
Universities aren't set up to do that kind of an activity. They said, that's a great idea. We couldn't possibly have that happen here at this university. And I'm hoping to change to turn change their mind about that, kind of indefatigable and trying to advocate these things. Other cities, I went down in fact met with with Erin and, in Tallahassee, which is one of the cities has done a really good job of really trying to promote itself and make itself available to promote entrepreneurship. So I think that the local community and municipal government can make a pretty big, change, make the permitting process, the zoning process, the other things easier to do and be more of a deliberately truly a partnership with the private industry instead of a, sort of, almost antagonistic, a dynamic that sometimes exist in, in some communities.
Jack: Um, this is more just an opinion that may not necessarily be an expert opinion, I'm asking for, but you're involved in it. My perception is we've got the 15% step up and the 10% step up in basis, rules that are part of the Opportunity Zone, but that 15% step up deadline, the investment has got to happen by the end of this year, which is fine, I guess if you're flying at 30,000 feet and say, “hey, we've given these guys 180 days to invest their money.” My concern, and I talked to a lot of folks on the development side about this, it goes right to what you were just discussing, the permitting process. So many of these localities that could benefit greatly from Opportunity Zone Investment, just their bureaucracy actively inhibits the ability of somebody who's got everything else going for them to just get the permits to start something. My sense has been that part of the law is going to have to have some kind of adjustment. What do you think? Is that likely? Am I reading this right?
Jay: Well they did try and address a frustration point of getting permits. People, I describe it the Opportunity Zone law, has a very unusual treatment of money. In a normal investment fund you put in your money, it's like canned goods. It's got shelf life. It can sit there until you need it. You know, when you find a good investment that's not it. We'll keep it on the shelf until we find a good investment. With Opportunity Zones it is kinda like fresh produce. You got to keep it moving along and you got the gain recognized.
Got 180 days to get into the QOF. You got a certain period of time to get from the QOF down to the QOZB then he got 31 months to get it out and deployed and pursuant to your written plan, all those things are, are, are kind of like delivering fresh produce down into the deal and value.
That's good, it's got refrigeration points along the way. Where you can let it sit there for a bit, but you got to keep it moving. And then that makes deals hard to do. It's especially hard to do when you've got a slow response from, you know, a local city or your town on key issues.
Zoning and licensing and permits and so forth are, the IRS did say, “We recognize that we're gonna take our 31 month role, which is pretty critical to developing businesses, and give you an extension if there's a delay that's caused by the, by the permitting process.” And that I had one person was like livid about it. I can't possibly be sure I'm going to have 31 months to get all my permitting done, never mind to build the building. It's like the building is the cart and the horse of the matters is that is getting the permitting done. So, by the way, they did make a tremendous change in the 31 months really made clear. It also applies to funding for businesses.
The first route tranche of regulations that you had to spend it for construction improvement of tangible property. This they said it could be any money that's used to improve a business cause I've got software companies and obviously wanting to spend their, their $5 million in investment in developing the software and not creating tangible property, but rather intangible property. That was a huge change.
Jack: You know that that reminds me of something we're running out of time here so we can't do it in this show. But I would like to maybe get you on the, on the phone sometime and talk about the intellectual property side of this, of this whole business.
Jay: Sure, let me just talk about two things that they did to help on the business side. Then we'll be done. One was the 50 percent of gross income has to come from the active conduct for the trader business in the Qualified Opportunity Zone. That's one of those things we say, “what does that even mean?” were we know about U.S. Source income foreign source income. We don't know about census track source income. I know. How do you source income to the 3,600 block, not the 3,900 block of Wabash in Chicago or Halston in Chicago.
And the rules became a proxy. It came with four different specific rules that could be safe harbors: one is wages, one is hours worked. If more than half are in the zone, that's going to give you a safe harbor to meet that test.
A third one is kind of a combination of where the management activity is and where the tangible property is. A fourth was just sort of a general facts and circumstances test. We think we can get most or all businesses into it comfortably on that. The intangible is a mess. Intangible is one of the things that they just continue to kick down the road.
They said, you've got to have a, substantial use of your intangibles in the Opportunity Zone. It has to be substantial use of your intangibles. It's very hard to source where intangibles are they came out with their usual percentage. They love to have a percentage of substantial means 40% but again it's that 40% of what they didn't answer what is so it's 40% times something has to be used in the Opportunity Zone and it's, you know, they wrestled with it.
It's a hard issue answer where you can tell where you use a computer or you know, the building is in the zone, the computers in the zone, you know, where you're using it. But where do you use a patent or a trademark or any of these other intangibles. There are a femoral and kind of everywhere and nowhere. So trying to figure out exactly how that rule is going to work still at the end of the day. I'm not worried about it.
They're trying very hard to make these pragmatic rules that will allow people to put businesses and obviously real estate developments into Opportunity Zones. The treasury really is on the side of trying to make these things work. Congress is strong in the side of trying to make things work. It's got bipartisan support, which I think will continue. So I hope to see it all work out in the right way. And I'm not worried about the intangible issue. We don't have the answer, but there's enough positive other stuff to suggest you know, they won't use that as a trip wire to try and blow up businesses at the end of the day.
Jack: Right. Well, it's going to come to that time of the interview that my favorite where we find out a little bit about the person rather than just about their expertise. I have a couple of questions. First one is Joseph Darby, the third. So , I have some family that has this particular problem. At some point these names develop a momentum of their own. Um, is there a Joseph Darby the fourth?
Jay: There is not.
Jack: Will there be?
Jay: I don't think so. But I won't say, I won't say never.
Jack: Jay's wife is sitting here off camera, shaking her head. No, no, no.
Jay: That's funny.
Jack: Okay. This is my favorite question of all. So, imagine for a moment that you get one day to be king of the world. You are the supreme ruler. You have sovereign power. However, it's only one day and you get to solve one problem. What problem are you going to apply your ultimate power to?
Jay: Oh, I think, problems are hard to solve and solving them begets new problems.
Jack: Oh, don't go all lawyer on me.
Jay: So, I probably…
Jack: You get to be king here. This is not a lawyer problem. This is a ruler.
Jay: All right. Well I think, I would…
Jack: May I make a suggestion. The designated hitter rule. There's a real problem.
Jay: I was actually thinking about that. The thing is that, I liked the designated hitter rule. The National League fans are all talking about how you should make the pitchers bat. But I still play baseball by the way. I played last weekend, you know, fast pitch baseball. I love hitting around real baseball.
Jack: Are you a catcher?
Jay: I'm not. I'm a DH at this point. Okay. And an outfielder. On occasion. But I don't have the speed.
Jack: He looks like he's got the hands of a catcher to tell you the truth.
Jay: Yeah. I like my baseball, but I liked the DH rule or the DH rules used in everywhere from little league, through a high school and college and replace cells who places and use these days as the National League. So, that, that's not the problem to solve.
I don't think I liked Charlie. Charlie Finley it was his idea. And they probably, actually, if I'm going to have that power, I'd focus on baseball because I think it'll spread happiness to the world. Cause I love baseball. And I like almost all of Charlie Finley's changes. Charlie thought that we should go from white baseballs to optical orange or optical yellow. And you know, at the time when he proposed that every tennis ball in America was white, how many way tennis balls have you seen as the last?
Jack: Zero
Jay: Oh yeah, they're all opticals. I think that having an optical baseball, he thought to speed up the game. He thought you should go to three balls and two strikes and he said that he had actually done research, you said throughout America, throughout baseball history, and had gone as high as eight, eight balls before you had a walk in the old history.
And he said there was no absolute magic about four and three. It's become kind of fixed in law. But he said three and two means the batters up there swinging, it's right there. The pitcher's pitching. So I thought, I thought, you know, that might be one of the biggest changes of all time. He came in with the designated pinch runner. He thought you should be able to put people in and out of the game. You don't have to use them once and put them on the bench with a small bench. So, I think it basically, we took all Charlie Finley's great ideas in baseball, it'd be the dynamic game and it always is in my mind. It should be for everybody else.
Jack: Okay. I'm going to follow up here. One question. We've got the computerized technology now that we can, we can see what a real ball and a real strike is. Could you as the king, as the ruler of the world, just implement that we let the computer call the balls and strikes that all by itself would. Nah, not going to happen, Huh?
Jay: Well, um, I, I'm not in favor of that because I think there's a dynamic between the catcher, the pitcher, and the empire, this kind of a fun part of baseball. Cause I played many, many years because a year or two ago I was at the plate. And, the guy kept pitching it inside and kept fouling it off. And finally they said, this next pitch is a strike. I don't care where it is. And so, I've been at bat for too long. That was a quintessential Bogan and baseball just basically get up there and we're gonna hit the ball. So those of you who play it like having the empire, but those of us who sit and watch the empire change the strike zone, batter to batter, it drives us out of our mind.
Yeah, that, well, one of the problems, I mean, I, I'm not a big fan actually of all the, the TV replay. It started with football and this is, it basically, it doesn't actually make the game fair. What it says is if we see it and it's a problem that we fix it, but we don't see it, then it's not a problem. We don't fix it. So, you know, which is not just decide how much you're going to fix it. And I don't think anybody's in favor of all these breaks and in football games or baseball games or the umps go over and look at it. You know, my neighbors don't have time. The answer is make a call, let's get going and…
Jack: Make a call and let's get it over with.
Jay: Perfection is the enemy of the good. And that's one of the places where I think that, we don't need to be perfect. We need to keep the game moving along. And, you know the television should tell you what happened that you shouldn't use the TV to play the game.
Jack: Those are wise words. Thank you. Jay. I think you'd probably make a good king for a day.
Jay: Okay.
Jack: Well, um, it's time to wrap it up if you've got any closing words for us.
Jay: Yeah, I think what's going to happen is that we're going to see a real breakout, as a result of this next, this most recent round of regulations. I think we know how to do deals. The way I described it, we were playing old man's golf as I call it, we hit the ball down the fairway. You don't hit it too far, but just keep it on the fairway and don't take any risks. Because a lot of stuff we didn't know whether it worked or not. When I was down in Florida event that Erin sponsored, I said, it's, it's like driving on the highway across the everglades. Okay. You got a path, you want to stay on the path. You don't want to go 10 feet off because it's swamp on either side. And people in Florida got that real clearly.
Oh, there's a path. It's going to stay on it. The path got widened. They made it clear how the rules work. We can swing for the green. Now go, full in and swing Irish, of our shoes are just never a good strategy. Golf. At least we can go, you know, a pretty good distance now. And it was some confidence about how the rules work. There's more work to be clarified, but we have enough now to be able to do deals. We can do business deals especially, which was the hard part to figure out. We can do it with leasing of real estate, including from related parties, not as structured related party leases and, and just general leases. We know how to structure the businesses to comply with the 50% test and we'll get business going and money going into the Opportunity Zone. I'm confident at this point.
Jack: Outstanding.
Jay: I'm happy to help anybody that would like to ask.
Jack: Well I was going to ask you if people want to get ahold of you, what's the best way for them to do that?
Jay: At my law firm, Sullivan Law, my email address is jbdarby@sullivanlaw.com. I've got, as you pointed out, materials that are my 21 questions. I date the latest run of proposed regulations designed to be a very functional, you know, focusing of the good parts of it and how it works. I'm happy to share those with anybody that wants to shoot me an email. You can also call me at 617-338-2985.
Jack: And I will remind our listeners that all of this information will be available on the podcast website, so you don't have to wreck the car trying to write it down.
Jay: All right.
Jack: Well Jay, thanks for being with us. On behalf of Jay Darby, I am Jack Heald for the OZExpo Podcast. Thanks for listening. Be sure to subscribe 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.
Jay: Oh, thank you, Jack. Thanks for having me on the podcast. Very excited to be here at Las Vegas for the Opportunity Zone Expo. And to be on this podcast.
Jack: We're giggling because we've already been talking for about 10 minutes before I turned to the recorder on. So, we're gonna just jump right into it. So, I'm just rewind for us. You took a math degree at the University of Illinois and then for some reason decided that that being a mathematician wasn't in the star in the cards for you.
Jay: No, in those days, it was back out so long ago that back in those days, math was sort of its own esoteric area. People couldn't figure out what you do with it in the real world. So, I ended up going to law school and about five or 10 years later, they learn to use math to all kinds of complicated options trading and synthetic derivatives
Jay: And, if had been 10 years behind in terms of the timing of my math degree, I probably would have been wealthier and happier, well wealthier anyway. And I am today. I'm pretty happy actually. I like practicing tax law.
Jack: So why law and for that matter, why tax law?
Jay: Well, I had a math background and I told you in the first round, I got out of law school and I was very young. I was 24. I couldn’t imagine being anything as dull and boring as an attorney. I became a sportswriter for five years and covered all kinds of sports in the Boston area.
Jack: That was in Boston. Okay.
Jay: Yeah, it was for the Boston. A real paper back then existed. The Phoenix existed back and I eventually wrote for a United Airlines inflight magazine and number of articles over the years.
Jack: So, we've already talked about this, but I'd just going to touch on it. Your favorite interview ever was?
Jay: Where I went with, I was, I was covering the Boston Red Sox in 1988 and their manager, Joe Morgan had just been promoted. They'd fired the prior manager end made him the interim manager. He went on a winning streak. They won about 20 out of 21 games or something. And I was supposed to interview him at the end of the game on a Saturday and he said, it's just been a long crazy day. They had this extra inning, and he said, can you come back tomorrow morning? I'll give you all the time you want to come back at 9:00 a.m.. So I went back to his office on a Sunday morning at 9 and walked in and it was Joe Morgan and Peter Gammons, who are probably the two best known sports writers on baseball in the entire 20th century.
Jay: The really the top two people it was the two of them, me listening, talking to Jim Morgan about baseball and Morgan had been a great baseball player in his sixties. He managed the minors. He'd been through it all. And why the most amazing conversations I've ever, maybe the most amazing conversation with baseball I ever heard in my life.
Jack: There's hardly anybody better I think to talk about baseball.
Jay: It was wonderful.
Jack: Okay. So, I'm going to treat you like the Joe Morgan of tax loss. So you end up as a tax attorney. That sounds like that would've been an interesting change of pace there to go from baseball to tax law.
Jay: It did. Well, there's a lot of numbers in baseball and I, thought, I'd been out of law school for five years and I had this a law degree from Harvard law school and it was like a black hole, had this required a huge amount of gravitational pull.
Jack: When did you sit for the bar? Was that before or after baseball?
Jay: Right after law school. While I still remembered stuff.
Jack: Okay.
Jay: So, I passed the bar and then spent the next five years, not practicing.
Jack: So, you were a sportswriter with a JD. I love it.
Jay: Yeah. It was pretty interesting.
Jack: From Harvard, no less. Did you get notes from Harvard saying, could you not talk about this?
Jay: No, I, it actually helped [that] it had nothing to do with sports writing. He would get people's attention and they want to come in and say, what the heck are you doing? Who are you, you know, so I get opportunities to, you know, get in the door and once you're in the door, if you talk fast, it's hard to get you out. So I was like a bad relative I was hard to get rid of.
Jack: Okay. So, let's talk about, let's talk about the Opportunity Zone.
Jay: Great.
Jack: You are a tax lawyer. Talk. We'll start general and we'll just drill down deeper and deeper.
Jay: Yeah. We came into the Tax Cuts and Jobs Act and enter 2017 when it was passed an existing law. There's kind of folded in at the last minute. Nobody had paid attention to it. Nobody paid attention even after it was enacted at first. They had a huge amount of mass. I described it as a, an iceberg and had a low visibility, but a huge amount of importance in mass. It took a couple months kind to say, Gee, what is this? I've worked on it almost continuously since it was enacted.
And it is unquestionably one of the most complicated, if not the most complicated area of, of U.S. Tax practice. I've dealt with all the other complicated things that the guilty regime has been putting in place. And the QBI deductions that are very complicated, this tops them all, even in bond pracs in other areas that are notoriously complicated and idiosyncratic.
This, I think is the most difficult area of tax law because of the combination of complicated concepts being integrated. And until recently, the lack of guidance. We just didn't know the answers to questions that we had to be able to answer in order to do deals. And that's why it's been kind of slow to get off the runway in a lot of ways.
Jack: Um, no. An awful lot of folks come on the show and talk about real estate now, which is great cause it's seems to be at least the low hanging fruit for Opportunity Zone, work. But you want to talk about the ongoing business side. So, let's do that. Probably the first question I want to ask you has to do with the updated guidance that came out in April. Apparently, we got some updates about leasing rules. How has the leasing of tangible property been clarified and what do we need to know about that?
Jay: Let me, that's a great question. Let me just step back and set the sort of table and then talk about that question. I always thought from the very beginning that the Opportunity Zone tax incentives are all about startup companies. Yeah. IPO's a new companies growing and exploding and value. What happens is it excludes all the gain on an investment. In real estate, if you have a good investment it will typically double every 10 years. If it's a good investment, it triples in value.
If it goes up by a factor of four, everybody calls it a home run. Well, I mean, you look at it like a Netflix or an Amazon or a, you know, name your Google name any sort of high tech startup. They don't go up two times.
They go up 100 times, you know, and so instead of a homerun and circling the bases, you get to just keep running around in circles as long as you want. Basically with that kind of investment and the idea of being able to exclude a hundred times or 25x or whatever it is. So, I mean this was always made to be for, you know, venture capitalists or private equity investors, much more so than real estate just because the upside is what it's all about and the upside is so much greater on a multiple basis compared to your investment then now.
Jack: I'm really glad to hear you say that. I really am.
Jay: Yeah. So I think that this was always meant to be a business incentive. The thing we had a hard time figuring out is how do you connect the business to the Opportunity Zone and the real estate. It's obviously real estate oriented, geographically oriented into these census tracks. And the rules weren't clear enough. We just didn't know the answers to the questions. The most important of which was the one you just posed, which was about leasing. They have a rule that said, substantially all which they conveniently developed said was 70%. The IRS is extremely good at translating phrases into percentages. It's one of the important parts of all tax regulations. And they said substantially all could have been anywhere from 70 up to maybe 90% they came in at the very low end, which is helpful at 70% but it said substantially all of the property, tangible property owned or leased, had to be qualified property and qualified property had to be purchased. So you had this sense of lease property is in the denominator of our 70% calculation, but not the numerator and that we had no idea.
And how do you value a lease? I mean a lease is a liability is not really an asset. You know, you've gotta pay to use the property. And so at the very least it's got an offsetting liability. So all kinds of questions that really sort of paralyzes from able to really move forward. We had a question, can we go into an Opportunity Zone and lease the property, which is what every business wanted to do. We hope that was the case. But these leasing rules seem to indicate that that wasn't a good idea or wasn't possible. And then there, the related question is if we can't do that do, we have to buy real estate and substantially improve it.
No business wants to spend all their other scarce capital on buying, improving property. They want to, they would improve their software or their services or whatever, their product and services in the business area.
So, all that pointed to the fact that we had to have a clear answer on how leases were dealt with. The first set of regulations which came out in October 2018 didn't answer that question. They gave us the 70% number. It didn't say 70% of what, it's literally, you know, times what can, and we need a multiple canned as it's called in mathematics.
And the result was that we were looking for as an answer to that, which came out in April. You know a few weeks ago and it was spectacularly positive. What they said was that a lease property could also count as good property. We were hoping, they'd say...
Jack: Thank you. I have, I've been trying to understand that. I get it now. Carry on. This is good.
Jay: Yeah. So you purchase properties, good lease properties also good. And so first of all it goes into the numerator as well as the denominator. So instead of being just a negative, we were so worried about it. We just hope that they come out and say lease property has zero value because you've got to pay fair market value for it. So it doesn't really have a lot of built in value. We just didn't want to have a bad number in the denominator.
Jack: Right.
Jay: Probably reverting to my mathematical background.
Jack: Yes, I've noticed that.
Jay: It's all about the math. It really is. I mean, you've got to get 70% and we said zero is good enough. As long as it's not a bad asset, we can figure out how to make it work. But he said there's no, no, it's a good asset.
It goes into the, the numerator, not only that, but they came out with a valuation methodology that's extraordinarily favorable. You take all your lease payments and you, and you discount them in a present value using an extremely low interest rate, which is very pro taxpayer. It means not only do you get to count it as a numerator number, you get to counter as a big number. They're treating you as if your credit worthiness is the same as the U.S treasury.
And so that all the payments get effectively. Yeah. Present value at a much higher number than probably your own personal rate would suggest. And so, the result is that we went from, how are we going to meet the substantially test for tangible property to a point where it's almost the other others, reverse. It's almost like how are you going to fail this unless you screw up cause you're going to have to be in O-Zone leasing property to a business. And once you do that, at least count, so much as good numbers in the numerator. You really would have to have to make mistakes with your handling of other tangible property, they ended up missing the 70% threshold in most cases. So it went from, “we don't know how to do this” to, “we're set, let's get going.”
Jack: That's the best explanation I've heard so far. You know, my two boys, we've been talking about doing some investing together and one them is a financial analyst and the other one is just a hardcore geek. And they just pepper me with these questions. You know, how do we do this? What are we doing? Those are really good questions. If we were buying a piece of property, I think I understand, but, um, when it comes to actually creating a business and building a business in an Opportunity Zone, I hadn't understood. So let's see. I guess we've talked about leasing, oh, well, leasing from a related party. Oh yeah. Another question that has come up.
Jay: Yeah, I mean, I mean there were a whole bunch of absolute critical questions, all of which got answered in the leasing area very favorably. As you said, the first is, can I go into an opportunity zone and just lease the property and use my money to buy my own business? The answer is yes. The second thing was how do I value the lease the answers very favorably and it goes into the numerator. The third thing is, can I have a lease from a related party?
And that was a real sticking point because lots of people actually have property in an Opportunity Zone that predates 2018 and so it doesn't qualify as good property and so they sort of wrestle with it. And they were quite all kinds of fairly convoluted suits, suggestions of your sell it to a partnership that you own less than 20% of the, so it's not a related party and all these kind of ways to contribute to or, or it's a bad asset that just contributed in the solution, which is simple, elegant and fabulous for deals going forward is you can lease it to yourself even if it's a related party, it counts as a bonafide lease, as long as it's at fair market value.
And it's got a couple other protections that are designed to prevent it from being abused. but the bottom line is that related party leases make it possible to create a structure where you don't give up the property, which most people didn't want to.
Jack: Right.
Jay: A, you get to put it into a business, on a lease basis that counts as a good asset for the lessee and, you're off and running. So, I think all of that combination of a leasing changes is probably the three biggest changes affecting the ability to create and grow businesses in an Opportunity Zone.
Jack: This was in the 168-page guidance that came out in April.
Jay: It was.
Jack: I started to read it and I said, there's somebody there, there'll be somebody who will explain this to me so I don't have to.
Jay: Yeah, it's a long dance law. It's very hard. I pulled out a 21 questions, which I'm happy to make available to participants in the Opportunity Zone Expo.
Jack: Is that going to be something that, um, we could make available online?
Jay: I think so, I'll follow up with you and we'll, we'll, we'll see.
Jack: Okay.
Jay: I picked 21 questions cause it's actually a dating game for kids these days. Yeah. You ask 21 questions is sort of a millennial dating game and I figured that it was time to go on a date with the OZ regs because we really needed to get to know it a whole lot better. It wasn't so easy. If we asked 21 questions to the regulations. Maybe we'll get some good answers. I've actually run in…
Jack: I've actual run into that, that 21 questions. So yeah, we're not gonna do that. Okay. Before the show we were talking about something that just made my head hurt. I have a high degree of confidence that you're going to relieve my headache here. How are section 1231 gains treated for the purposes of investing an eligible gain. Oh, into a Qualified Opportunity Fund.
Jay: Uh, well that's one of those ones where we got an answer that had the benefits of clarity but maybe not the benefits of functionality.
Jack: Yeah.
Jay: Cause we know that this law was one many, many things that made it a complicated and difficult as it was not especially well drafted. They originally started off saying any sale of property gain for any sale of properties eligible. The first set of guidance back in October, 2018 and said, no, no, it's gotta be capital gain. Okay. And then the answer was, well, you can get capital gains from selling a capital asset, but you also get capital gain from selling a 1231 asset, which is an asset used in a trade or business, for depreciation and held for more than one year. And let me just tell you there's a ton of 1231 assets in this world.
If you walk into Costco, everything you see except for the people either inventory or property used in a trade or business, you know, there's everything there is, is depreciable property, that you can sell and if it sells at a gain, you get the capital gain if it sells a loss, ordinary loss troubles at 1231 has this netting rule of losses against gains to come up to the net amount, which is really the big capital gain or ordinary loss. We just didn't know if you could isolate out one piece of property.
The IRS unfortunately said you cannot take one piece of property, recognize the gain for 1231 purposes and call that capital gain because 1231 is all about the netting and they felt they had to have maintained some fealty to the netting concept and to net it you had to be at the end of the year.
So, they came over the rule that logically makes sense in the IRS has perspective. You take 1231 gain, you net at the end of the year, wherever the net amount is, if it's positive, you got 180 days from December 31 to invest but as you and I chatted, but beforehand I got people selling in real deals, in real time selling companies. And what they'll do is they'll sell a business.
They'll have the gain, they'd like to roll it over to the next business, which is the kind of thing in an Opportunity Zone. All the things, the act is trying to promote. The trouble is that they'll have gain from capital assets, which can be invested from the day that the gain occurs. But they'll also have 1231 gain might have a lot of it. In the case of riff, it's, I've got real estate component to the business or you know, it was a substantially a real estate business.
You'll have this split between the investment 180-day date, starting for the capital gains in the day it's sold versus the 1231 which doesn't start until December 31. Example I gave, if you sell a business on February 1st okay, you may have capital gain that you've got 180 days to invest. So, you got to get ahead and invest by you know, something one of the magnitude of August 1st you know, 180 days later. But the 1231 gain, you can't even be, you begin to invest until December 31.
So, the same transactional event will create two paths of gain. We've had discussions that people that are actively involved in kind of dealing with the IRS. And we've already said we've got to go back and have some effort to try and change that so it can match up. When you sell a business, then you get gain out of it. You want to be able to roll it over all is one opportunity, you know, a reinvestment into an Opportunity Zone investment at that point in time.
Jack: Now, as I did my research, it seems like you have been involved with the government, at least in an advisory role, about how we need to interpret these things and how it needs to be clarified for those of us on the investment side. Tell us a little bit about that.
Jay: I'd be delighted to. I've been fortunate. I was involved by the Real Estate Round Table in Washington, which is one of the maybe the premier, a group representing the real estate industry in Washington on Capitol Hill. We got pulled into a service select group of people to interface first of all with the Real Estate Round Tables collection of people to come up with good policy ideas and then go in an interface with the, IRS, the Treasury and the people that Joint Committee on Taxation who represent the congress. And we've gone in several meetings and presented, both written materials and then followed up with face to face meetings and just explain what we think are reasonable, ways to interpret the rules and the laws. I'm happy to say that many of the things we've proposed were accepted.
We weren't the only people proposing some of the good ideas. There were others, but we were certainly one of the central groups that were helping shape the IRS's response in pragmatic ways. And we think that the second set of guidance in particular was excellent work on the part of Treasury. There’re things that we, got, I'll, this is, we didn't get. We listed Treasuries reasons for all their decisions. And we'll go back with a few more examples. Like I said, with the 1231, we got of have a kind of an ability to make, make it integrate with when sale of a business can generate, you know, two different streams of money, more than 180 days apart. So, if I was just one simple example, but it's been, it's been a real pleasure to be involved with the people at the very high ends of an American tax practice. And, at the IRS and the Treasury there, they've done an excellent job at the Treasury of interpreting very hard law and doing a great job and you know, Mike Novi and, Dan Coyle skin, those people who've done a superb job of playing the government's role in this whole process.
Jack: You know, you're not the first person I've heard say that. As just kind of your generic run of the mill taxpayer, my perception of the IRS and Treasury is not positive. I've heard a lot of folks say very positive things about how this particular part of the act was administered. Obviously, some claims, some complaints about the fact that it was a little confusing and possibly thrown in at the last minute. But in terms of the government's response after the fact, it's been very positive. Is that unusual in your experience?
Jay: I don't think it is, although I think that in this particular area there's been a real convergence of effort to make a complicated but extremely well-intentioned law functional so we can accomplish the goals that we've set out to do. It started with a senator Tim Scott, who was that was the original person advocating and supporting the bill. He managed to reach across the aisle, which to his credit and to everybody's credit is hard to do these days given how divided and polarized Washington is. He got to Cory Booker to cosponsor the law. Tim Scott did it because he really cared. He really wanted to see money going into, you know, underserved, underinvested areas of the country and really help people out, which it, by the way it has done it.
But my understanding is that Opportunity Zones, have appreciated about 20% on average across the country, since the law was enacted as the value proposition's already gone up. But lots of things are going into these areas in positive ways. The IRS, and the Treasury folks who've tried to implement it in a way that's consistent with the code, but also faithful to the goal of trying to promote investments in these Opportunity Zones. They've been criticized.
They've said it's going to lead to gentrification and all kinds of things. But you know, I think a lot of people said, no, it's going to lead to jobs in areas that need jobs and businesses going in. It's not just a, I mean we talked about maybe the high tech business. You've got a software company, brand new software company in an Opportunity Zone. But those people also want to have Dunkin Donuts and CVS and all the other kinds of things that go with it. So, it brings with it the other aspects of things that are needed in those areas. I mean there's nothing like having a CVS drug store or a coffee shop in a place that doesn't have either of those things. I can tell you I need the coffee more than the drugs. I need both, over time.
Jack: I was talking with Erin Gillespie who was involved with the creation of the Florida Opportunity Zones. And she told me a couple of stories about individual communities in Florida that had done just some amazing things. Successes, a really cool situation, very creative. There wasn't anything Opportunity Zone specific about this particular activity. What this community did was they bought a piece of property that was, I think essentially abandoned. They refurbished it, and turned it into a lounge for the local cops, stocked it with soft drinks and food and just made it available for the cops to come by. And so, it was a high crime area, you know, very unappealing in terms of investment. And by taking this building that somebody had that was not going to be used for anything else. They basically turned it into a satellite police station, constant police presence and that all by itself, you know, helped to reduce crime. And I just thought it was an extraordinary, a solution to kind of a gnarly problem. I want to get that out there because I think that's the kind of thing that when folks are looking at these high crime areas, how do we solve that particular problem? That's not necessarily a financial problem. There's more to it than, than just investment.
Jay: So yeah, Erin is a hot ticket. She and I worked together and in some areas that I've been trying to get actively involved in what are called a P3, public-private partnerships. One of the terrible problems right now with the law is that it's driven by entrepreneurs. And I think that the logic of it is good. There are tons of tax incentives to try and help areas. There's a New Markets Credits and Empowerment zones and Go Zones and all kinds of different things they've tried to do. And they always end up being kind of bureaucratic and difficult to administer and people just say it isn't worth the hassle to deal with the government to get near the incentives. This is really just saying we're going to use taxes and have entrepreneurship go in and, and drive the bus.
And I think it's probably the most likely way to get a lot of energy and a lot of change. the trouble is that involves entrepreneurs making private profit. The cities and towns just don't kind of instinctively do well in giving land to someone to turn a profit that they're not part of.
We're trying to come up with good ideas for a 501C3s or for cities and towns, to come up with a partnership, a strategy where they are putting in land in a partnership expecting to make a profit. They may, there's a lot of criticism that comes with that in this day and age. If you're a political person who is sort of turning money over to someone's going to turn a profit. But it also turns it over to people that are likely to run it better than it might be run if it's a public utility.
I'm not gonna be too critical of public utilities or publicly-managed, activities. But we all have a sense that entrepreneurship with the energy and the drive can produce, a qualitative improvement. So, trying to make those work is a challenge.
I've, I've talked to, a 501c3 organization, a major university, about literally doing their own PPM, doing a private offering, and they've got a piece of real estate they'd like to have developed in an Opportunity Zone. And I said, own it. You know, just bring in investors and an entrepreneur to manage it, to build a project in turn it into dynamic area and just go into business yourself. They almost had a heart attack.
Universities aren't set up to do that kind of an activity. They said, that's a great idea. We couldn't possibly have that happen here at this university. And I'm hoping to change to turn change their mind about that, kind of indefatigable and trying to advocate these things. Other cities, I went down in fact met with with Erin and, in Tallahassee, which is one of the cities has done a really good job of really trying to promote itself and make itself available to promote entrepreneurship. So I think that the local community and municipal government can make a pretty big, change, make the permitting process, the zoning process, the other things easier to do and be more of a deliberately truly a partnership with the private industry instead of a, sort of, almost antagonistic, a dynamic that sometimes exist in, in some communities.
Jack: Um, this is more just an opinion that may not necessarily be an expert opinion, I'm asking for, but you're involved in it. My perception is we've got the 15% step up and the 10% step up in basis, rules that are part of the Opportunity Zone, but that 15% step up deadline, the investment has got to happen by the end of this year, which is fine, I guess if you're flying at 30,000 feet and say, “hey, we've given these guys 180 days to invest their money.” My concern, and I talked to a lot of folks on the development side about this, it goes right to what you were just discussing, the permitting process. So many of these localities that could benefit greatly from Opportunity Zone Investment, just their bureaucracy actively inhibits the ability of somebody who's got everything else going for them to just get the permits to start something. My sense has been that part of the law is going to have to have some kind of adjustment. What do you think? Is that likely? Am I reading this right?
Jay: Well they did try and address a frustration point of getting permits. People, I describe it the Opportunity Zone law, has a very unusual treatment of money. In a normal investment fund you put in your money, it's like canned goods. It's got shelf life. It can sit there until you need it. You know, when you find a good investment that's not it. We'll keep it on the shelf until we find a good investment. With Opportunity Zones it is kinda like fresh produce. You got to keep it moving along and you got the gain recognized.
Got 180 days to get into the QOF. You got a certain period of time to get from the QOF down to the QOZB then he got 31 months to get it out and deployed and pursuant to your written plan, all those things are, are, are kind of like delivering fresh produce down into the deal and value.
That's good, it's got refrigeration points along the way. Where you can let it sit there for a bit, but you got to keep it moving. And then that makes deals hard to do. It's especially hard to do when you've got a slow response from, you know, a local city or your town on key issues.
Zoning and licensing and permits and so forth are, the IRS did say, “We recognize that we're gonna take our 31 month role, which is pretty critical to developing businesses, and give you an extension if there's a delay that's caused by the, by the permitting process.” And that I had one person was like livid about it. I can't possibly be sure I'm going to have 31 months to get all my permitting done, never mind to build the building. It's like the building is the cart and the horse of the matters is that is getting the permitting done. So, by the way, they did make a tremendous change in the 31 months really made clear. It also applies to funding for businesses.
The first route tranche of regulations that you had to spend it for construction improvement of tangible property. This they said it could be any money that's used to improve a business cause I've got software companies and obviously wanting to spend their, their $5 million in investment in developing the software and not creating tangible property, but rather intangible property. That was a huge change.
Jack: You know that that reminds me of something we're running out of time here so we can't do it in this show. But I would like to maybe get you on the, on the phone sometime and talk about the intellectual property side of this, of this whole business.
Jay: Sure, let me just talk about two things that they did to help on the business side. Then we'll be done. One was the 50 percent of gross income has to come from the active conduct for the trader business in the Qualified Opportunity Zone. That's one of those things we say, “what does that even mean?” were we know about U.S. Source income foreign source income. We don't know about census track source income. I know. How do you source income to the 3,600 block, not the 3,900 block of Wabash in Chicago or Halston in Chicago.
And the rules became a proxy. It came with four different specific rules that could be safe harbors: one is wages, one is hours worked. If more than half are in the zone, that's going to give you a safe harbor to meet that test.
A third one is kind of a combination of where the management activity is and where the tangible property is. A fourth was just sort of a general facts and circumstances test. We think we can get most or all businesses into it comfortably on that. The intangible is a mess. Intangible is one of the things that they just continue to kick down the road.
They said, you've got to have a, substantial use of your intangibles in the Opportunity Zone. It has to be substantial use of your intangibles. It's very hard to source where intangibles are they came out with their usual percentage. They love to have a percentage of substantial means 40% but again it's that 40% of what they didn't answer what is so it's 40% times something has to be used in the Opportunity Zone and it's, you know, they wrestled with it.
It's a hard issue answer where you can tell where you use a computer or you know, the building is in the zone, the computers in the zone, you know, where you're using it. But where do you use a patent or a trademark or any of these other intangibles. There are a femoral and kind of everywhere and nowhere. So trying to figure out exactly how that rule is going to work still at the end of the day. I'm not worried about it.
They're trying very hard to make these pragmatic rules that will allow people to put businesses and obviously real estate developments into Opportunity Zones. The treasury really is on the side of trying to make these things work. Congress is strong in the side of trying to make things work. It's got bipartisan support, which I think will continue. So I hope to see it all work out in the right way. And I'm not worried about the intangible issue. We don't have the answer, but there's enough positive other stuff to suggest you know, they won't use that as a trip wire to try and blow up businesses at the end of the day.
Jack: Right. Well, it's going to come to that time of the interview that my favorite where we find out a little bit about the person rather than just about their expertise. I have a couple of questions. First one is Joseph Darby, the third. So , I have some family that has this particular problem. At some point these names develop a momentum of their own. Um, is there a Joseph Darby the fourth?
Jay: There is not.
Jack: Will there be?
Jay: I don't think so. But I won't say, I won't say never.
Jack: Jay's wife is sitting here off camera, shaking her head. No, no, no.
Jay: That's funny.
Jack: Okay. This is my favorite question of all. So, imagine for a moment that you get one day to be king of the world. You are the supreme ruler. You have sovereign power. However, it's only one day and you get to solve one problem. What problem are you going to apply your ultimate power to?
Jay: Oh, I think, problems are hard to solve and solving them begets new problems.
Jack: Oh, don't go all lawyer on me.
Jay: So, I probably…
Jack: You get to be king here. This is not a lawyer problem. This is a ruler.
Jay: All right. Well I think, I would…
Jack: May I make a suggestion. The designated hitter rule. There's a real problem.
Jay: I was actually thinking about that. The thing is that, I liked the designated hitter rule. The National League fans are all talking about how you should make the pitchers bat. But I still play baseball by the way. I played last weekend, you know, fast pitch baseball. I love hitting around real baseball.
Jack: Are you a catcher?
Jay: I'm not. I'm a DH at this point. Okay. And an outfielder. On occasion. But I don't have the speed.
Jack: He looks like he's got the hands of a catcher to tell you the truth.
Jay: Yeah. I like my baseball, but I liked the DH rule or the DH rules used in everywhere from little league, through a high school and college and replace cells who places and use these days as the National League. So, that, that's not the problem to solve.
I don't think I liked Charlie. Charlie Finley it was his idea. And they probably, actually, if I'm going to have that power, I'd focus on baseball because I think it'll spread happiness to the world. Cause I love baseball. And I like almost all of Charlie Finley's changes. Charlie thought that we should go from white baseballs to optical orange or optical yellow. And you know, at the time when he proposed that every tennis ball in America was white, how many way tennis balls have you seen as the last?
Jack: Zero
Jay: Oh yeah, they're all opticals. I think that having an optical baseball, he thought to speed up the game. He thought you should go to three balls and two strikes and he said that he had actually done research, you said throughout America, throughout baseball history, and had gone as high as eight, eight balls before you had a walk in the old history.
And he said there was no absolute magic about four and three. It's become kind of fixed in law. But he said three and two means the batters up there swinging, it's right there. The pitcher's pitching. So I thought, I thought, you know, that might be one of the biggest changes of all time. He came in with the designated pinch runner. He thought you should be able to put people in and out of the game. You don't have to use them once and put them on the bench with a small bench. So, I think it basically, we took all Charlie Finley's great ideas in baseball, it'd be the dynamic game and it always is in my mind. It should be for everybody else.
Jack: Okay. I'm going to follow up here. One question. We've got the computerized technology now that we can, we can see what a real ball and a real strike is. Could you as the king, as the ruler of the world, just implement that we let the computer call the balls and strikes that all by itself would. Nah, not going to happen, Huh?
Jay: Well, um, I, I'm not in favor of that because I think there's a dynamic between the catcher, the pitcher, and the empire, this kind of a fun part of baseball. Cause I played many, many years because a year or two ago I was at the plate. And, the guy kept pitching it inside and kept fouling it off. And finally they said, this next pitch is a strike. I don't care where it is. And so, I've been at bat for too long. That was a quintessential Bogan and baseball just basically get up there and we're gonna hit the ball. So those of you who play it like having the empire, but those of us who sit and watch the empire change the strike zone, batter to batter, it drives us out of our mind.
Yeah, that, well, one of the problems, I mean, I, I'm not a big fan actually of all the, the TV replay. It started with football and this is, it basically, it doesn't actually make the game fair. What it says is if we see it and it's a problem that we fix it, but we don't see it, then it's not a problem. We don't fix it. So, you know, which is not just decide how much you're going to fix it. And I don't think anybody's in favor of all these breaks and in football games or baseball games or the umps go over and look at it. You know, my neighbors don't have time. The answer is make a call, let's get going and…
Jack: Make a call and let's get it over with.
Jay: Perfection is the enemy of the good. And that's one of the places where I think that, we don't need to be perfect. We need to keep the game moving along. And, you know the television should tell you what happened that you shouldn't use the TV to play the game.
Jack: Those are wise words. Thank you. Jay. I think you'd probably make a good king for a day.
Jay: Okay.
Jack: Well, um, it's time to wrap it up if you've got any closing words for us.
Jay: Yeah, I think what's going to happen is that we're going to see a real breakout, as a result of this next, this most recent round of regulations. I think we know how to do deals. The way I described it, we were playing old man's golf as I call it, we hit the ball down the fairway. You don't hit it too far, but just keep it on the fairway and don't take any risks. Because a lot of stuff we didn't know whether it worked or not. When I was down in Florida event that Erin sponsored, I said, it's, it's like driving on the highway across the everglades. Okay. You got a path, you want to stay on the path. You don't want to go 10 feet off because it's swamp on either side. And people in Florida got that real clearly.
Oh, there's a path. It's going to stay on it. The path got widened. They made it clear how the rules work. We can swing for the green. Now go, full in and swing Irish, of our shoes are just never a good strategy. Golf. At least we can go, you know, a pretty good distance now. And it was some confidence about how the rules work. There's more work to be clarified, but we have enough now to be able to do deals. We can do business deals especially, which was the hard part to figure out. We can do it with leasing of real estate, including from related parties, not as structured related party leases and, and just general leases. We know how to structure the businesses to comply with the 50% test and we'll get business going and money going into the Opportunity Zone. I'm confident at this point.
Jack: Outstanding.
Jay: I'm happy to help anybody that would like to ask.
Jack: Well I was going to ask you if people want to get ahold of you, what's the best way for them to do that?
Jay: At my law firm, Sullivan Law, my email address is jbdarby@sullivanlaw.com. I've got, as you pointed out, materials that are my 21 questions. I date the latest run of proposed regulations designed to be a very functional, you know, focusing of the good parts of it and how it works. I'm happy to share those with anybody that wants to shoot me an email. You can also call me at 617-338-2985.
Jack: And I will remind our listeners that all of this information will be available on the podcast website, so you don't have to wreck the car trying to write it down.
Jay: All right.
Jack: Well Jay, thanks for being with us. On behalf of Jay Darby, I am Jack Heald for the OZExpo Podcast. Thanks for listening. Be sure to subscribe and we will talk to you next time.
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