The Opportunity Zone Expo Podcast

Mike McMahon - Tax Wizard Talks QOF structures, and has some surprises

July 31, 2019 Mike McMahon Season 2 Episode 14
The Opportunity Zone Expo Podcast
Mike McMahon - Tax Wizard Talks QOF structures, and has some surprises
Show Notes Transcript

Mike McMahon dives deep into the intricacies of structuring a Qualified Opportunity Fund, (QOF). He's got some surprising advice for folks who believe there's no way to make a REIT work in the OZ.

Host: Jack Heald
Guest: Mike McMahon

Jack Heald:

Welcome back everyone to the OZExpo Podcast. I am your host Jack Heald and I am joined today by Mike McMahon who is the Executive VP for Portfolio Management and Director of Tax at RXR Realty. That is a long title.

Mike McMahon:

Thanks Jack. It's great to be here. Yeah, it's a long title and I've been here a long time, so I guess it makes sense. Um, I've been with the RXR for 22 years started back in 1997 as the only person in the tax department and uh , you know, back then it was a publicly traded company Reckson Associates. We ran the public company, public REIT for about 12 years, grew it from a $300 million family company to a $6+ billion publicly traded REIT that we, then, sold the SL Green and uh , the executive team kind of retrenched as a private company that's now known as RXR. And in connection with that, I started managing a portfolio of suburban assets, mostly some class B office product and that was, let's see, 2010 surely if the markets , uh, kinda crashed. So I've got some really good experience dealing with some troubled real estate. But now, I'm pretty much solely back in the tax realm at this point in my career.

Jack:

I was gonna ask you how in the world you do portfolio management and tax at the same time, at least at that level, that just seems-

Mike:

Yeah, it was a challenging time for a number of years. But, you know, with the growth of RXR , we're now actually the fifth largest commercial landlord in New York City. We have roughly about $19 billion assets under management and we're all over 500 employees at this point. We, as a private company, are doing so many different things that my time was needed back in tax, so they kind of took the portfolio management mostly away from me at this point, and I'm happy to be back focusing solely on tax at this point in my career.

Jack:

It's if it takes a special kind of person to even have that sentence come out of their mouth, delighted to focus on tax.

Mike:

Yeah. So , you know, I've always had a thing with numbers. Um, Ever since I was a kid, my dad would actually leave me math problems in the morning before he would be for work. And, I would either do them in the morning before school or come home after school and do all the , you know , the math problems and he'd come home and graded for me and, you know, so I've always had to stick with numbers. And uh, you know , just loved to playing cards with him. We used to play 500 rummy, casino and, you know, just different card games. I actually got to do accounting. It's funny I thought that's what he did for a living. He worked for Citibank in their account management group and I just always thought that was accounting. So I, I actually went and decided to go to accounting 'cause I thought he was an accountant. I've learned later on after I got my accounting degree that he was really an accountant. So..

Jack:

Dad, I went into the wrong, the wrong business. Okay, so let's talk about your work specifically with the Opportunity Zone. This is what this show's all about. So, RXR gives us kind of the high level, what is RXR doing with Opportunity Zone investing in , I'm guessing, property management as well?

Mike:

Yeah, so, you know, again RXR is a, it's a private company. We're fully integrated real estate operating company manager. We own , as I mentioned, a number of commercial properties in New York City and some in the surrounding suburbs. We are now getting into residential development and management. So, when the Opportunity Zones program came out , first off it was something that just as a tax professional I was extremely interested in because it's not often that you see new tax regimes enacted, especially ones that have such a large potential for positive social impact, so I was very interested in it from the beginning. And when I started to look at the zones once they were designated , it occurred to me that RXR actually has a number of properties located within Opportunity Zones. So I've been interested in and focused on Opportunity Zones, I'd say spending nearly all my time focused on Opportunity Zones for the past 16 months or so. Um, so as the legislation come out, I've printed out the regulations and read them from cover to cover. I think that when the second batch came out, I stayed up until one in the morning reading those regs, and a lot of people were looking at me funny the next day. So..

Jack:

Yeah, you know, everybody in the business was, for that last- I don't know, four weeks was in the Treasuries about that radio printings, try that you're about ready to release these, and we were all waiting on pins and needles. April 17th - I remember it clearly. I didn't read it though. I'm not a tax professional life but leave that up to you, guys.

Mike:

Yeah , yeah, um , nope. I read it cover to cover. I had a meeting right in early the next morning and it was funny because somebody came in with them printed out and , yeah, we were both commenting on how we stayed up breathing them all night. Couple of tax geeks.

Jack:

Yeah. Fun parties I bet you guys have, huh! So, you also serve on the Real Estate Roundtable and I was like, with this focus on Opportunity Zones..

Mike:

Yes. So they have a tax policy advisory committee and I'm a member of that advisory committee, and for those who aren't familiar with Real Estate Roundtable, they're an advisee group for the real estate industry and they're very , um, very influential actually, so I'm a member of the Tax Policy Advisory Committee. When Opportunity Zone legislation came out, they formed a working group of members of their tax policy committee to focus on the legislation , reading through the legislation and eventually the regulations to see what issues everybody can come up with, what issues people were having with the legislation, what we needed to see enacted in future guidance from Treasury. So , I'm actually a part of a smaller subset of that Opportunity Zone working group is about six or seven of us. It had been hyper actively involved and I'm working with Real Estate Roundtable and actually meeting directly with Treasury after the first set of regs came out to give them our impressions on the legislation as well as our suggestions and guidance for what we needed to see in the second set of regulations when they came out so that we can get this program kind of off the ground and running. And, I was happy to see when the second set of regs came out that they did, in fact, incorporate a number of the things that we had discussed with them although there were a few items that still need some clarity, and I'm hopeful that they'll clarify that and give us some additional guidance with the next turn of the regulations.

Jack:

Well, as a tax professional, your opinion here really does matter. What are some of those places where you are still looking for guidance?

Mike:

So , you know, just a couple of areas. One is, and they give us guidance on this originally with respect to vacant properties. There was some guidance in the existing regulations with respect to empowerment zones or enterprise zones that said if the property had been vacant for a year on the date of zone designation or, I'm sorry, a 12 month period that included the data zone designation that you can then put that property back in the service and treat it as a good asset for a Opportunity Zone funds. Unfortunately, Treasury misread their own regulations and didn't see the language that said, "on the date of zone designation", so they were concerned that people were going to just vacate assets for a year and then try to put them back into service and claim Opportunity Zone benefits on that. What I , you know, pointed out to a Treasury official recently at a Real Estate Roundtable meeting was that you can't do that under the regulation that was there for empowerment and enterprise zones. It had to be vacant on the data's own designation either 12 months before, 12 months after, or you have some 12 month period that included that date. So if you, nobody knew what the zones were going to be, if you found out you were in a zone the following day and then vacated the building, it doesn't count. So I think Treasury will change this rule. I think five years is way too long. I believe a number of people have commented on that. So I'm hopeful that maybe what they'll do is cut the five years down to two or three years and then maybe, additionally, sight the existing regulation in the enterprise and empowerment zones that allow for that one year vacancy if it was vacant on the date of zone designations . So , we're working with them on that. Hopefully, they'll clarify that. I think the big thing that needs some clarification is some of the rules that would be helpful for multi -asset funds. So, Jack, I'm sure you've heard a number of large real estate organizations going out trying to raise half a billion dollars, billion dollars, some even more than that to go out and buy multiple assets to hold in a fund. You know, there's still some issues regarding multi-asset funds specifically the legislation as written says you have to sell your interest in the qualified Opportunity Zone fund in order to get the benefit of tax free growth of that investment. Treasury did come out with some helpful guidance that allows for funds to sell assets and then distribute the proceeds after 10 years, however, that piece of the regulations that was issued can't be relied upon until it's finalized. So, we're trying to get Treasury to put some reliance language and so that you can rely on it before it's finalized. There's some other , you know, some other issues also with respect to , multi asset funds. They gave us another helpful provision in the new regs that says to the extent that an investor is invested in the QOF, they could take that investment in the QOF and essentially contributed to a partnership, kind of like an aggregator or a theater partnership. So, you know, what a lot of people that are setting up multi-asset funds have been doing is using a, what I call a parallel LLC structure, parallel structure where you set up a series of LLCs , you know, let's say there's six LLCs or 12 LLCs, each of which qualifies on its own as a qualified Opportunity Zone fund. And, each of those qualified Opportunity Zone funds would then own a qualified Opportunity Zone business, which is really the entity that would own the real estate. So, you know, what people are doing is setting up these quote unquote funds where people are investing but they're not investing in a single entity, they're investing in six entities or 12 separate entities, each of which is a QOF. Now, this new regulations came out said to the extent that somebody invested in the 6 QOFs or 12 QOFs, they could take that investment in each of those entities and contributed to a feeder partnership. Um, but I guess there's some concern that Treasury might come back and say, you know, if this was all done with the intent of contributing it to this theater partnership from the get go that , you know, there's this step transaction risk because the investment may be deemed to have been made into the theater directly and not into the QOF and that would not fit within the confines of the Opportunity Zone and legislation. So, very technical issue but one that has raised some concern from number of fund managers and advisors . So we're hoping that we can get them to say that in a situation where it's prearranged, investor goes into the QOF and enrolls it into the theater that they won't apply step transaction doctrine to that.

Jack:

I want to make sure I understand the problem. You're not the first person I've heard mentioned this, but I think when I first heard it, I didn't understand it and I'm, perhaps, may have more clarity now. As I understand it, we've got a multi asset fund that- I've invested in a multi asset fund. That fund can sell properties, what it sells some of the properties that it owns and I can take a distribution, now before or after the 10 year period?

Mike:

So you're going to want the fund to do that after 10 years in order for you to get the tax free treatment.

Jack:

Certainly note that no question about if it's sold before the 10 year holding period, but-

Mike:

Right, before 10 years absolutely taxable.

Jack:

Once the 10 year holding period is done and the fund sells off part of the assets, is there some question about how I as an investor can take the tax, the tax benefits there?

Mike:

So if the fund sells the assets after 10 years, they should be able to distribute proceeds to you and allocate gain to you assuming we're talking about a partnership, right? You'd get an allocation of the gain that they had on the sale of the asset. Now, the way the regulation works is that any capital gain would be, you'd be able to exclude any capital gain from your tax return. The problem right now is that this regulation can't be relied upon. They didn't put reliance language in there so until that regulation is final, there's question as to whether or not , a partnership QOF can hold multiple assets because I don't think Treasury would do this, but they could decide to pull this from the final regulations. And now what you have is a single partnership QOF with multiple assets and the only way for investors to get the exclusion of gain would be for that partnership to sell itself to a single buyer that's interested in owning the multiple assets that QOF owns .

Jack:

Wow, okay.

Mike:

Yes. So, that's the problem with not putting the reliance language in. Had they put the reliance language and I think it would've made it a lot easier for people to use a single partnership QOF and to acquire just multiple assets below that.

Jack:

Right. So, I'm guessing then that you're, now I realize in your role at RXR you are not giving tax advice to other people that's your job is..

Mike:

Correct. Yes, let's make that clear. This is just me speaking personally about how I feel.

Jack:

Okay. So you, speaking personally about how you feel, how would you advise somebody who's, who's looking at either creating or setting up a fund or investing in a fund? Would you just recommend single asset funds?

Mike:

So, I think there's a placed multi-asset funds. Uh, and I think there's structure that work currently. I think that the last set of regulations that were issued , once they are finalized, we'll bake everything clear, at least that's my hope that they don't change that tenure rule , and that they , you know, they don't apply the step transaction doctrine to people that have multiple QOF that they want to insert an aggregator in between the QOF and the investors. So I think if I was setting up a multi asset fund today, I would set it up as parallel LLCs, bring the investors into each separate LLC. The only challenge or downside of that is investors would be getting multiple k ones, one from each of the separate QOF. But, you know, I think that investors that get K-1 , don't necessarily care if they're getting one K-1 / six K-1s. You know, they're going to have a tax prepare or prepare the return and they'll have to pay a little bit more for each additional K-1. But , uh , you know, as long as you're getting the the tax free growth and they're assured of the proper tax treatment after 10 years, it winds up being a small price to pay. And, I think that, ultimately, when the final regulations are issued that there'll be ways to simplify the structure.

Jack:

Okay. Good to know. In my research and I saw that you have a good bit of experience in REITs and then you, you actually brought it up earlier in the conversation. What's your opinion about using a REIT structure for Opportunity Zone investment?

Mike:

Sure. So there's, there's basically two forms of an entity that you can use for an Opportunity Zone fund. One is a partnership, either an actual partnership entity or an LLC that's treated as a partnership. The other option would be to use a corporation and I think for the most part, people that are using a corporate structure in the real estate world will be making REIT elections for those corporate entities. So , you know, the reason I think that some people like the REITs structure , you know , it's familiar to a lot of people now at this point. A REIT been around for a long time and um, you know , it's in some ways easy to raise money in a REIT structure, the reporting arguably is a little bit easier and in some ways it's, I would say easier on the investor side. They're just getting a 1099 instead of a K-1 where there, you don't have in the pickup all these different line items from the K-1. Um , I've been dealing with REITs forever. It feels anyway. As I mentioned, started my career here with the RXR back when it was a publicly traded REIT Reckson. We were publicly traded for 12 years, sold the public entity, now we've been private for about 12 years and I have, let's see here, RXR's probably about 60 separate REITs in our organization structure so I deal with REITs on a daily basis. Uh, love REITs for lots of different reasons, lots of different structuring reasons. I don't like REITs at all for the Opportunity Zone legislation for the, you know, Opportunity Zone program. It's just in my opinion, not the right vehicle. I think there's just too many limitations with the REIT in the Opportunity Zone world. My biggest issue or, you know, the biggest challenge with the REIT as a QOF is that, you know Jack, if you think about how this Opportunity Zone program works, right? Let's say you had artwork and you know, you paid $1 million for it, you sold it for 2 million, you have a million dollar gain. You wanted not pay tax on your $1 million gain, you hear about this Opportunity Zone program , and you're like, hey, that's great. I'm gonna take my million dollar gain, I'm going to put it into an Opportunity Zone fund. Because that million dollars is gain and you're deferring that gain , you actually start with a zero basis in your investment. So you put $1 million in but you're starting with a zero basis, and that's true, whether you put that million dollars into a REIT QOF or into a partnership QOF and you won't get any basis for that million dollars until you've held that investment for five years. And at that point you get a 10% step up or 10% of your basis back. You all live for another two years, you'll get another 5% of your basis. So in a REIT QOF you start with a zero equity basis, you're not getting any basis until year five. And at that point you're only getting $100,000 basis. What that means is that REITs aren't going to be able to make any distributions to you, the investor, unless it's from earnings. And if you're familiar with how REITs are taxed, you know , REITs generally owned depreciable real estate. So they generate cash flow, but that cash flow is covered by depreciation. So. For every $10 a cash, they may only have $5 taxable income, they may have $0 of taxable income. So to the extent they want to make a distribution, it has to be a taxable distribution to you. Meaning you're gonna treat it as a taxable dividend, otherwise they can't make that distribution to you without triggering a portion of your original million dollar gain because what would otherwise be in a normal REIT, a return to capital is not a return of capital when you don't have any basis. Once you, once you get a distribution in excess of your basis from a REIT, that's treated as a partial sale of your REIT interest. So you're, you know, these REIT QOFs I'm gonna have a tough time making any distributions for the first five years if they're doing any kind of development or redevelopment projects because it's going to take time to first complete the project then to lease it up and then once they start generating cash flow , um, there's still going to be depreciation to offset that cash flow. So it's going to be a real challenge I think for a lot of these REIT QOFs to make any distributions in the first five years. Now looking at the other structure, partnership structure. Partnership QOF, as I mentioned, you put your million dollars in, you starting, well you know, also with a zero equity basis. But the beautiful thing with partnership is that a partner in a partnership gets allocated a portion of the partnership level debt. So to the extent you're investing in a partnership QOF that owns depreciable real estate, either direct or through a subsidiary qualified Opportunity Zone business , you'll be able to get allocated a portion of that debt through the partnership and that gives you debt basis. And that debt basis means that you can get distributions from a partnership QOF without it triggering any gain because it's just going to eat into your debt basis. The other beautiful thing with that is partnerships, that have development projects or even an operating asset, can refinance the asset and give you a debt finance distribution without a triggering gain. You can't do debt finance distributions and REITs without a triggering gain because it's going to be essentially , you know a distribution in excess of your basis 'cause you're not getting allocated any of the REIT level debt. So, you know, from that standpoint, I think partnerships have a very large advantage over REITs when it comes to using a partnership as the cue off as opposed to REITs

Jack:

I'm not being a tax expert. I can't even comment on what you said other than that makes, well, that makes a lot of sense. It really does. And I, you know, I've asked a few folks about the REIT structure and you're the first guy who has explained that bit over that actually makes sense to me. And I , you know, I guess if I was running my own fund, I would definitely say , uh, listen to Mike, let's set this up as a partnership, not as a REIT.

Mike:

Yeah. Look, I think there's a place to REITs, you know , I think that if somebody were to set up a , say a, you know, a parallel QOF structure or even a single QOF structure , um , you could use a REIT down below as the qualified Opportunity Zone business as long as you had other qualified Opportunity Zone businesses that were partnerships and flowing, get through to the investor so that the investor has some kind of a debt basis through the partnership. You know, there are some advantages to using REITs down at the QOF level, but I wouldn't use the REIT at the QOF level. I think it's just a, there's too many limitations on using the REIT at that level.

Jack:

Mostly what you're doing here is demonstrating to me why I want tax professionals on my team. 'Cause I'm literally, my eyes are glazing over.

Mike:

Yeah. Look, it's important to have the right tax people in place. Absolutely.

Jack:

Oh Geez . So tell us a little bit about yourself. You grew up in, you're New York born and bred. Where'd you go to school?

Mike:

So I went to college of Staten Island, go figure and lived there, went to school there, got my four year accounting degree there and then they actually had a joint program with Baruch College. Both our city universities and Baruch has an excellent accounting program so I got my Master's MBA in Tax from Baruch , started work, you know. My last semester of my Master's program at a small , well, mid-sized accounting firm , Kenneth Leventhal, which actually wound up merging with Ernst and Young and becoming Harrison Young's real estate group. So , I spent three and a half years combined between Kenneth Leventhal and Ernst and Young, and Reckson was my biggest client at the time I knew a bunch of the guys here because they were XZY people. So when I was looking to leave EY they brought me in here and I've been working here, like I said, for the last 22 plus years. Uhm..

Jack:

You must like it. 22 years. Wow.

Mike:

You know, it's funny, I've told the story before when I was interning at Kenneth Leventhal. I was in the tax department and, you know, we have two tax season and it wouldn't be much work in tax so they'd kind of loan us out to the audit side. And , I had a manager who was a mentor of mine and said, "Hey I have this guy, you know, it's an audit manager, a senior manager needs some help with the spreadsheet." So , I went over, got the information from them, I'm working on the spreadsheet and had a couple of questions so I call him up and he picks up the phone, I asked questions, he goes, "I can't believe you call me these questions. Just get it done." Boom, hangs up the phone. Okay. You know, so I do my best on the spreadsheet and, you know, bring it back to them and drop it off. I go back to my manager, I said, "I don't ever want to work for that guy again. I just can't believe, you know, he was so rude and obnoxious. Never let me work for him again." Long behold, that's the CFO that I've been working with here for 22 plus years. So , you know , it's all good.

Jack:

It all worked out.

Mike:

Yeah.

Jack:

Well, Mike, if folks want to know more about RXR or just want to talk to you about anything they heard on the show here today, what's the best way to do that?

Mike:

Yeah, sure. My email address is my first initial, M for Michael, and then my last name McMahon, mmcmahon @rxrrealty.com .

Jack:

Alright , very good. And I'll remind our listeners this information will be available in printed form on the Podcast website. So don't wreck the card looking for a pen to try to write it on your palm. Well, Mike, I appreciate your time with us here today. Before I let you go, have you got any last words for us?

Mike:

Uh, no, that's it .

Jack:

That's good, I like that. Short and to the point. Well, very good. For Mike McMahon of RXR Realty, I am Jack Healed of the OZExpo Podcast. Thanks for joining us today. Be sure to press the subscribe button there on whatever podcast app you use, and we will talk to you next time.