OZs vs. 1031s, DSTs, And Other Tax Mitigation Strategies, An OZ Pitch Day Panel

Investing in Opportunity Zones can be an effective tax mitigation strategy for High Net Worth investors. But when are OZs the right investment structure to use when considering taxation and overall portfolio construction strategy?

In this panel from OZ Pitch Day Summer 2022, Louis Reynolds, CEO of Synergistic Exchange Solutions, and Nick Rosenthal, managing director at Griffin Capital, discuss how Opportunity Zones compare to other tax mitigation strategies, including Section 1031 exchanges, Delaware statutory trusts (DSTs), and Section 721 UPREITs.

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Episode Highlights

  • The most popular sources of capital gains that get deferred into Qualified Opportunity Funds.
  • The four main differences between Opportunity Zones and Delaware statutory trusts (DSTs): timeframe, return, taxes, and principal.
  • Considerations for High Net Worth investors when it comes to deciding between OZs, 1031s, and DSTs.
  • The sizes of the DST and OZ marketplaces, and how they compare to each other.
  • The inherent investment objective differences between 1031s, DSTs, 721s, and Opportunity Zones.
  • A case study for when an Opportunity Zone may be more beneficial than continuous 1031 deferral.
  • Some of the sticking points with regards to investments in Opportunity Zone businesses.

OZ Pitch Day Panelists

Louis Reynolds and Nick Rosenthal on the Opportunity Zones Podcast

About The Opportunity Zones Podcast

Hosted by OpportunityDb.com founder Jimmy Atkinson, The Opportunity Zones Podcast features guest interviews from fund managers, advisors, policymakers, tax professionals, and other foremost experts in opportunity zones.

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Show Transcript

Jimmy: Excellent. So, the panel this morning, the educational segment this morning, we’re gonna focus on OZs, Opportunity Zones, versus 1031s, DSTs, and other tax mitigation strategies. Louis joins us today from Synergistic Exchange Solutions. Nick Rosenthal joins us today from Griffin Capital. Louis, very quickly, just, like, in maybe your elevator pitch, 20 seconds or less, can you introduce yourself and tell us a little bit about Synergistic Exchange Solutions?

Louis: Sure. We’re a fairly simple organization and that there’s only two things that are required to buy real estate, one is equity and the other is debt. As a friend of mine used to say, “You can buy real estate with no money down, but it’s a little hard.” And so as Synergistic Exchange Solutions, we work with really two different groups of folks out there in the industry. We work with a lot of different opportunity zone as well as other real estate groups that are putting together a lot of the great real estate programs and deals that you see in front of you.

And so we help those organizations find equity. And then the second thing we do is we help financial advisors connect their clients and their equity with those sponsors of great real estate programs, you know, in the country. So, you know, on a very simple level, we’re just kinda keeping the wheels greased, if you will, of finding equity and helping equity get into great real estate across the country. So, you know, on one level, we’re very agnostic because we work with so many different sponsors across the country, and at the end of the day, we’re just lovers of real estate and we wanna see more of it purchased and benefit a lot of different investors across the country. So, we’re a pretty simple organization from that standpoint.

Jimmy: Absolutely, Louis. And Nick will be our other panelist today. Nick, can you quickly introduce yourself and tell us about Griffin Capital?

Nick: Yeah. Thanks, Jimmy. My name is Nick Rosenthal. I oversee the capital formation for the private market strategies here at Griffin. Griffin was founded in 1995, and over that time, we’ve been involved in about $22 billion of real estate transactions across multiple sectors of the property market and investment strategy structures. We’ve been active in the opportunity zone fund space since 2019, really focused on the multi-family sector. And we have been fortunate enough to be entrusted with about $1.3 billion of investor capital to place in this space. And we’re very pleased with the investments that we’ve been making and the opportunity to improve the communities in which we’re active.

Jimmy: Fantastic. Well, thank you, gentlemen, both for being here with us this morning. I’m gonna launch a poll question right now. When Louis and I were chatting yesterday, he asked me, “Hey, where do your folks, where do your users and your listeners and your viewers typically get their capital gains from? What is the source of your capital gains?” And I told him, “Well, we’ve asked that question in the past, but why don’t we throw up a poll question in the beginning of our panel?” And so here’s the poll question for everybody out there today. “What is or are your source or sources of capital gains that you are considering deferring into a qualified opportunity fund?” And you can select more than one.

We’ve got publicly traded securities like stocks, bonds, ETFs, mutual funds, real estate, very common as well, privately held business. Maybe you have some collectibles like gold or art or jewelry or other types of collectibles. Comic books is one I’ve heard from one or two investors over the past couple of years. And then, of course, we do have some folks with Bitcoin or other crypto assets. So, I’ll leave that up on the screen there for another minute or two and we’ll reveal those results shortly. But Louis, let’s dive in here. I’m gonna turn to you first. In broad strokes, what is the main difference or the main differences between opportunity zone investing and doing a section 1031 exchange or making an investment into a Delaware Statutory Trust?

Louis: Right. And I think that’s kind of the quintessential question and the starting question, if you will. And again, thank you, Jimmy, for having us aboard. I just absolutely love this topic of real estate in general. And I heard somebody joke the other day that since the first opportunity zone fund was done when the Dutch bought Manhattan from the Indians and turned it into an incredible investment, made it Manhattan and downtown New York, that opportunity zones have been an amazing investment for the last 400 years. So, I thought that was a little bit of a stretch, but at least it was a good starting point, right? Here, to me, are the kind of the quick four differences. And we like to call those the four Ts of the differences between DSTs, Delaware Statutory Trust, which is a very common place for investors to shield gains on real estate from taxation and opportunity zones.

Those 4 Ts are timeframe, meaning, do you have a 4 to 7-year timeframe or do you have a 10-year timeframe? It’s kind of one of the good first starting places to begin because for a lot of investors, that 10-year timeframe might just be too long for them, for others, that 4 to 7 might be too short. So, timeframe is a good place to start. Second T is total return. Do you want your total return from cash flow or do you want more of your total return from gains, from appreciation that come on the investment? And that’s clearly one of the distinctions between most DSTs and most opportunity zones. The third T is taxes. The o. zones will give you a deferral and then some tax-free status down the road. Both of those are great. The DSTs will give you deferral and the ability to keep deferring until you die. And then the DSTs will give you the great advantage of having a step-up on debt, which the opportunity zones don’t have. So, the tax issues, both of them are fantastic from a tax side, but there are some subtle differences that it’s good to walk through just so you make sure down the road, one or the other is gonna be better or worse for you.

And then the last T is the principal. I don’t know if you noticed, Jimmy, but I cheated on the T. I had to throw a “The” in front of principal, but, you know, I’m not that smart a guy, so I couldn’t think of another T word. But when I say the principal, I think that’s one of the hidden advantages for opportunity zones, is the fact that the only money that you need to invest and really can invest in an opportunity zone is the gain. You don’t invest your principal into an opportunity zone. And the reason I say that is from a strategic portfolio planning standpoint, there’s some real advantages to being able to pull your principal out of real estate or some other asset and have that free and clear to you to do a lot of other different investing. And so you’re just investing your gains. And so that becomes one of the distinct advantages too with a opportunity zone over a Delaware Statutory Trust whereas in a Delaware Statutory Trust, generally, you’re needing to invest all of your principal and all of your gains for a full-tax deferral. And so those are kind of the four quick, what we call the Ts, timeframes, total return, taxes, and the principal, big overview of the differences.

Jimmy: That’s great, Louis. Thanks for that. I wanted to end our poll question here and display those results on the screen right now. So, we’ve got… Let’s see. The majority of you have gains stemming from the sale of real estate, about two-thirds of you. Nearly one-third or a little more than one-third have gains from publicly traded securities, and then a quarter of you have gains from privately held business, and then non-zero amounts of collectible gains, and about 10% from Bitcoin or other crypto assets. So, that’s an interesting poll result there. I think I’ve seen a little bit of a shift over the last 6 to 12 months, more gains coming from real estate, fewer coming from publicly traded securities. We’ve had the big drawdown in the stock market over the last six or seven months here.

Nick, let’s turn to you, though. Louis gave a great overview of his four Ts. I guess it was a silent T on principal there. But you handle a lot of client capital. You have a lot of investors on your Griffin Capital platform, Nick. What are some considerations that your investors are coming to you with? What are some of their concerns when they’re taking a look at either doing an opportunity zone investment, or a DST, or a 1031 exchange? What are some of the considerations and concerns that you’re hearing from actual investors on your platform?

Nick: Yeah, Jimmy, as you mentioned, you know, we’ve raised a little over $1.2 billion of investor equity. So, we’ve got a few thousand investors. And one of the most fun parts of this business is being able to talk to these investors about the variety of the types of liquidity events that they have, but real estate is one that keeps coming up just because of the challenges right now in finding replacement properties in the 1031 market and the limited amount of DST inventory that exists. So, we’re talking to real estate investors every day. And one of the things that we tell them is that, you know, the 1031 exchange is a deferral program with unlimited duration and the QOZ program has limited deferral but affords tax-free growth over 10 years. And then there’s some other considerations that they might want to think about.

And we start with this. Whatever you are investing in, whether it’s a 1031 investment or an opportunity zone fund investment, is an investment first and foremost and it’s a tax strategy secondarily. So, the same diligence that you would make or go through to make a investment selection of any kind, you should be doing here as well. And as you think about sort of where the strategy fits in your personal planning, you know, there’s some important things to consider. So, for real estate investors, we always ask them, you know, “What’s your basis relative to your gain?” And this is what Louis was alluding to, which is that one of the great tools here with the opportunity zone fund investment is the ability to separate basis and gain and create immediate liquidity. And one of the reasons why that’s important is because most real estate investors are selling an asset that is generating income, and because of the nature of an opportunity zone fund investment and the substantial improvement clause, you’re investing in something that’s initially development or redevelopment. So, generally speaking, no current income.

So, can you take your basis back and create some income if that’s important to you? “Do you need the income right now?” is a question that we ask. Do you value immediate liquidity? Do you want access in the future to your capital? Right? The opportunity zone fund after 10 years gives you the ability, right, to get a basis step-up, take your liquidity from that fund if that fund has had a liquidity event or if that asset has been sold if it’s an individual asset opportunity zone investment, and do with it what you wish. Whereas the exchange is a deferral program in perpetuity. As long as you continue to exchange, as Louis said, you swap until you drop.

And then we ask folks, “Are there structural or estate planning issues that you wanna consider? Do you own your real estate in partnership? Is it valuable to you for estate planning purposes to separate that ownership going forward?” And if that’s the case, the opportunity zone fund might be a good planning tool. We talk to a lot of investors that are selling real estate and they don’t necessarily want their kids to have to go into business in the future with their partner’s kids. So, there’s a lot of things that we see, you know, as considerations that investors should make on the estate planning and financial planning side as long… And I’ll get back to this. As long as they’re comfortable with the underlying investment, first and foremost, because the tax benefits and the absence of a good underlying investment are not gonna be that helpful.

Jimmy: Yeah. Good point there, Nick. And you can’t let the tax tail wag the investment dog, as I like to say sometimes. What about the size of the marketplace, the available options out there? Louis, you cover DSTs and qualified opportunity funds on your platform at SES and Focal Point. What are the differences? And give us a sense of the scale of how many opportunity zone funds are out there and how many DSTs or 1031 exchanges are being conducted.

Louis: Sure. Sure. Absolutely. And it is a very large market out there, which is to the advantage of all the investors out there too. They’ve got a lot of choices, and fortunately for our industry, there’s just a lot of high-quality options out there, which are great. From a very broad basis, the DST, the Delaware Statutory Trust market last year was about $8 billion in exchanges. And that’s individuals that are selling real estate and then wanting to defer their taxes, come into another real estate program. There were about $8 billion worth of equity done, about $16 billion worth of total real estate investments on the DST side.

And then the o. zone side, you know, it’s, you know, fairly new. We’ve only had o. zones really for about three or four years now. And that industry is running at about $30 billion or so in equity. And there’s a lot of available projects out there, which is great. It’s 25% of the United States, which was, you know, fundamentally carved off into o. zone opportunities.

And the nice thing about those, Jimmy, is they really run the gamut. There are folks that are doing, you know, multi-family apartment complexes. We see single-family deals that have come up that have been pretty popular in the last year or two. We also see, you know, the industrial. And there are, you know, those larger trends that we all know about that have an impact on real estate and some of them pretty substantially.

I’ll give you one negative, one positive, right? One of the negative trends we’ve been fighting for the last 10 years is that folks aren’t shopping, right? They go to Amazon and a package shows up on their doorstep. And the negative of that is retail malls might not be the greatest investment out there or at least they weren’t for the last 10 years. Maybe they’re the greatest investment to get. I don’t know. But that fundamentally changed that sector for a year.

On the other side of it, the industrial side, which was the direct beneficiary of the Amazon world, if you will, it meant that you needed more and more warehouses closer and closer to people so that when somebody, you know, clicks on, “I wanna buy some tennis shoes,” and 30 minutes later, he’s lacing them up on his feet in his living room, those tennis shoes have to be pretty close in some industrial warehouse.

So, there have been a lot of changes out there and there are a lot of good groups out there. And I would say Griffin Capital is a great example of one of those groups that, you know, is finding those areas that not only are a good viable investment fundamentally, but they’re also going to take advantage of some of those natural advantages that are coming to a particular market or the market in general. So, Jimmy, I don’t know if that’s what you were looking for, but that’s where my brain went.

Jimmy: That’s fine. I always like seeing where your brain is gonna go, Louis.

Louis: No [crosstalk 00:16:24].

Jimmy: It’s just fine. I think you answered the question.

Louis: Okay. Great.

Jimmy: We’ve got a few minutes left. We’ve got a couple of questions coming in. By the way, if you do have any questions throughout today’s presentation or today’s entire event, use the Q&A tool in your Zoom toolbar if you missed that announcement earlier. We’ll try to get to as many questions as we can. Kind of to wrap things up here in the last few minutes, Nick, I wanna turn to you and then we’ll get to one or two questions, hopefully.

What are some of the investment objectives or the difference in how investors need to consider their overall investment objectives when it comes to doing a 1031 or a DST versus doing an opportunity zone investment? There’s some inherent structural differences between the types of investment product that the two different vehicles can invest in. And maybe also if you want to, you can touch on Section 721 UPREITs and when that may come into play as well for particular investors looking for tax mitigation options.

Nick: Yeah. So, I guess, fundamentally, to answer the first question, I think it comes down to, you know, the things that I articulated early on, which are the questions we asked our investors that come to us kind of contemplating 1031 or QOZ. And our position is, depending on what your objectives are from a financial planning and estate planning perspective, they’re both very viable tools, right? One is not better than the other. As a blanket statement, they’re both applicable in different situations.

So, I think, you know, most investors coming out of 1031 exchanges have a current income associated with that property that they’re relinquishing. And most opportunity zone fund investments don’t have current income. So, the question becomes, how important is current income to you in your financial plan? Number one. Number two, again, do you need immediate liquidity? Is there a basis here that you can take back to solve that potential liquidity desire or a need for you as an investor?

And then, you know, I would say the opportunity zone fund investment is a combination of growth and income, right? It’s generally development or redevelopment for the first three, four, five years as that portfolio or that project is being built and stabilized. And then you’ve got current cash flow from that point forward over the remaining duration of the investment. So, you know, I view the 1031 exchange as predominantly a deferral tool. I view the opportunity zone fund as both a growth and income investment without current income initially. And then, again, some of those issues for our investors as to what they’re trying to solve for. Do they want immediate liquidity? Do they want eventual liquidity?

I had a call yesterday with a financial advisor who represents a young professional sports athlete. And this person had a rental property that they were selling. And they were selling it for about $1.2 million, and they had a $600,000 basis. Current income, because of this person’s earning capacity, wasn’t that important to them. They liked the idea of taking the initial basis back and just rolling the gain or part of the gain because the individual is young, so 10 years from now, being able to take that capital, get a fair market value basis step-up and do something else with that money was compelling as opposed to having to continue to exchange from that point forward to continue the deferral cycle.

So, you know, it’s a different tool for a different investor depending on what they’re trying to achieve, but that’s generally how we have these conversations with our clients who are contemplating understanding the differences between the two. I like the 721 tool for 1031 investors. I think it’s unique in a lot of ways to the standalone DST or 1031 exchange into a single asset. It allows an investor to UPREIT their beneficial interest into a diversified portfolio, and then in the future, potentially depending on the liquidity of that vehicle and what is allowed inside of that vehicle that they’re exchanging into, which is generally a REIT, the ability to convert that operating partnership unit to a common and sell it down and control their own tax consequences moving forward.

So, I think for older investors, it’s particularly a nice tool so that their beneficiaries have the ability to, you know, get the basis step-up, convert to common, and then create liquidity for themselves. But I think it’s just a way of getting diversified exposure through an exchange eventually. But again, you’re gonna have to like what you end up in at the end of the day because if you end up in a REIT that doesn’t perform well, when you exit that REIT, you’ve created a tax consequence for yourself. So, again, it’s about the diligence on the underlying investment, but if you like it, it’s a great tool for the right investor.

Jimmy: Well, that’s great. Thanks for the insight on 711s there and the different investment objectives that need to be considered between these varying tax mitigation programs. We’ve got less than a minute to go, and then I’ve gotta bring our next presenter on stage, but I did wanna make sure we got to one of the questions here. Sorry if we don’t get to your question. I’ll try to answer them later on during today’s programming. But Timothy asks, “What are some of the sticking points with investing in QOZ businesses?” There haven’t been a lot of businesses that QOFs are rolling out. I wonder if either one of you, gentlemen, had any thoughts on that topic?

Nick: My comments would just be there’s a lot of compliance requirements to adhere to. And that’s a general comment sort of across the industry. And so it’s important that as a investor doing diligence, you understand what that sponsor or an investment manager or business has to do in order to stay compliant. And, you know, are they able to do it because they have the infrastructure and they’re paying attention to it or have run public reporting companies in the past?

The other thing that I think is important is, what is the viability of that business long-term through economic cycles? Because if you’re running an operating business and you have to be in business for 10 years to maximize the benefits, which is the growth and the value of that business, that business is likely to encounter different economic cycles over that period of time. So, what is the capitalization of that business? What is the viability of that business long-term through various economic cycles? Those are the things that I would think about.

Jimmy: Well, we’re a minute over time here. I wanna get David from Origin Investments up very soon here. But Louis, any parting words from you before we head out today?

Louis: No. Just thanks for having us and we really appreciate this. The industry is in a real vibrant time with a lot of, you know, equity being raised in a lot of different direction. And there’s really a lot of exciting things coming to market, so, at SES we’re happy to be kind of a part of that that links those sponsors with equity and with advisors. So, thanks for having us, Jimmy, very much. And great seeing you too, Nick.

Nick: You as well. Thank you, Jimmy. And you folks are in for a good next presenter. Origin is a great firm. So, stick with the program.

Jimmy: They are, indeed. Thank you both. I really appreciate your time today. Thank you.

Louis: Sounds great. Have a great great day, folks.


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OZ Pitch Day

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