How To Due Diligence OZ Funds, An OZ Pitch Day Panel

In this panel from OZ Pitch Day Fall 2022, Kirk Walton and Gordon Goldie review strategies for performing due diligence on OZ funds.

Episode Highlights

  • What investors should consider when evaluating Qualified Opportunity Funds (QOFs);
  • The importance of finding good projects, fund sponsors, and product structure;
  • Avoiding the temptation to “let the tax tail wag the dog”;
  • Distinctions in the level of diversification across different OZ funds;
  • A preference for multi-asset funds given the ability to enhance the “Super Roth IRA” potential and risk mitigation via diversification;
  • How to analyze the economics of a deal, including carried interest and various fees that fund managers charge;
  • Examples of reasonable and unreasonable fees in OZ deals;
  • Evaluating multiple levels of fees and “crystallization” events in fund structures;
  • Live Q&A with webinar attendees.

Today’s Guests: Gordon Goldie and Kirk Walton

About The Opportunity Zones Podcast

Hosted by 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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Episode Transcript

Jimmy: I’ve known both Gordon and Kirk for quite a while in the opportunity zones industry. Gordon Goldie is a partner and CPA at Plante Moran. Plante Moran’s an accounting firm that has pretty deep expertise in opportunity zone strategies. Kirk Walton and Gordon, you’re joining us today from the Detroit, Michigan area, I believe. Is that right?

Gordon: Exactly. Yep.

Jimmy: And Kirk Walton is joining us from Eagle, Idaho. He’s a managing partner at GPWM Funds. But today’s panel’s going to focus on how to due diligence opportunity zone funds. So, as a potential investor into a qualified opportunity fund, what are some things that you look for? How do you incorporate QOFs into an investment portfolio? And what are some things that investors should really be on the lookout for when they’re considering a QOF? And Kirk, I’ll start with you. What do you look for typically in a qualified opportunity fund?

Kirk: Thanks, Jimmy. It’s great to be here. First, the opportunity zone fund really is primarily used for real estate. It can be used for operating businesses. We’re using it for real estate. And, you know, as part of a diversified portfolio, investors are gonna hold a slice of that portfolio in real estate. The opportunity zone fund, at the end of the day, becomes the most tax-efficient way to hold your real estate slice of the portfolio. How do you due diligence and what do you look for at a big, broad level? Good projects and good fund sponsors. You look at the fees, you look at the location, you look at the type of project. There’s so many variables that are underneath each of those headings, but you really gotta look at both. And it takes a good fund structure and a good set of projects to make a good opportunity zone fund investment.

Jimmy: And Gordon, I’ll turn to you now just high level before we really dive in here. What do you look for in a qualified opportunity fund? You’ve got a little bit of a different perspective than Kirk, you’re a CPA. What are some things that you advise your clients on?

Gordon: Yeah. I guess one of the first things would be, you know, just being careful not to let the tax tail wag the dog. You know, just because you had a big capital gain event doesn’t mean that you should invest all of it into an opportunity fund. I mean, certainly could make sense to invest part of it, but you know, don’t just assume that you’re better off trying to invest all of it into an opportunity fund just to get the opportunity zone benefits. And so stepping back and looking at where the investment fits into your bigger, broader portfolio and making sure that investment strategy fits and such, and that you’ve got whatever diversification and such. You’re not really investing too much into say, real estate or certain types of real estate or whatever. So, just kinda, you know, stepping back and looking at the big picture there. But once you’ve determined, you know, how much or whatever of your capital gain event you might wanna invest in that opportunity fund, I agree with, you know, everything that Kirk said. You know, one thing that has probably been said way too much, but it probably not enough also, is that, you know, the tax incentive doesn’t make a bad deal into a good deal. So, you need to really make sure that it’s a good deal. And looking at the fund sponsor and their experience and, you know, those sort of things is certainly important.

You know, from a diversification standpoint, you know, you’ve got some options. You know, obviously, there’s a lot of funds out there that are single-project type funds, and so, you know, those could be great but just making sure that that fits in with what you’re trying to accomplish with your entire portfolio. There’s also funds out there that are more diverse, you know, that are pools of projects. And so, you know, just understanding the different spectrum there and, you know, how it fits into what you’re trying to accomplish are probably some of the big things. And then, I think Kirk alluded to it also is the fee structure of the funds are important. You could have a great project, but if too much of the benefits of it are being sucked up by the people who are putting it together, then it’s probably worth making a pass on something like that. So, just understanding what fees are being taken out and including carried interest and other fees that are paid for putting the deal together or annual asset management fees are important to pay attention to.

Jimmy: Yeah. Absolutely. Fees can be a big part of this discussion. And a bad fee structure or fees that are too heavy-handed could really make or break an OZ deal. I wanna talk more about fees, fee structures, and what investors should look out for in a few minutes, but let’s put that aside for now. Kirk, getting back to you, Gordon brought up the point that there are a lot of different types of opportunity zone funds. Some of them are multi-asset funds with a diversified strategy. Some are multi-asset funds with a narrow focus. Some are single-asset funds, which are even more narrowly focused, obviously. What are your thoughts on what investors should look for, how they should bring opportunities and funds into their investment portfolios with respect to whether doing single-asset deals or multi-asset deals?

Kirk: Well, I’ll be blunt. I lean towards the multi-asset funds because of the super Roth IRA potential for the opportunity zone fund structure. Under the final regulations, you can recycle cash flow, and for the next five to seven or eight years, depending upon if this legislation gets passed and extended. What that means is you can build out a portfolio of properties and when they cashflow or when you have a cash-out refi event, or when you sell part of the parking lot, or when you sell the entire asset, that money goes from the projects back up to the fund, and each fund has the option to recycle that money back into another project and another project, and another project. But almost every fund that I’ve seen or looked at sends that money back out to the investors. You know, right now, if you have a capital gain event, you’re at a fork in the road.

And as you saw Chris, put up, it’s better to go into the opportunity zone fund because of the tax advantages than, you know, if you go into a taxable way. Just like with a Roth IRA, if you have a stock that pays a dividend inside your Roth IRA, you don’t send the dividend out to your checking account to invest it somewhere where it’s gonna be taxed. If you do not need the cash flow, you keep it inside the Roth IRA tax shelter and have it compound on itself and grow more and more. The big opportunity that’s often missed in the opportunity zone space is that you can compound inside your opportunity zone fund. And for certain investors, especially those that don’t need the cash flow, that can really create multi-generational wealth by compounding and creating a broad footprint of multiple properties that’ll all grow tax-free. And that all will provide depreciation deductions that aren’t subject to depreciation, recapture.

And that last benefit is a hidden benefit, not talked about enough. But that creates, where you really have to scrutinize “Do I want it stabilized? Do I wanna sell it and recycle or do I wanna cash out refi tax-free and recycle and continue to own and operate?” Even if I’m not getting as much cash flow, I own it, and I get depreciation deductions, which are definitely worth something. As a tax lawyer and a guy who’s prepared tax returns for decades, there’s real value in those depreciation deductions. So, that’s why I like multi-asset, because the only way to compound and compound and compound is to buy more assets, and that’s a really big deal to investors.

Jimmy: No, that’s great thoughts there. And I liked your point about the super Roth IRA nature of opportunities and investments. You caught my attention early on Kirk, several months, or maybe it was a year or more back when you were one of the first I heard of talking about a lot of investors had concerns like, “10-year hold. That sounds like a long time.” But there were a handful of us, Ashley Tyson included, and he turned me onto this idea, and then I heard you talk about it, Kirk, as well. You shouldn’t be asking yourself, “How soon can I get out of this investment?” But rather, I think the way that you look at it, Kirk, and the way that I look at it, is you should be asking yourself, “How long can I keep this money in this structure? How long can I let this capital eat tax-free?” So, that’s an interesting point there, right?

Kirk: Yeah. That’s right. Like if you’re a wealthy family, you’re gonna own a certain slice of your portfolio in real estate. You can either own it inside an opportunity zone fund where you don’t pay tax on your real estate, or you can cash it out and put it into some real estate asset that you are gonna pay tax on. And when you look at the uneven playing field that was created, you know, if you have an opportunity zone fund asset that earns 5% a year, it’s probably equivalent to a taxable asset earning closer to 8% or 9% a year. And you know, if you have apartments that are in an opportunity zone, and across the street there’s not an opportunity zone, and you have apartments there, those two buildings are gonna perform about the same. The rents are gonna be what the rents are gonna be. You’re better off to hold it in a way where you’re not paying tax on it. So, like I said at the beginning, the opportunity zone fund is the most tax-efficient way to hold the real estate slice of your portfolio, whatever that slice should be.

Jimmy: Sure. Well, Gordon, I wanna turn back to you now. Kirk likes diversified fund, multi-asset funds. Do you agree with him or do you have a different perspective on the best types of funds for investors?

Gordon: Yeah. I tend to agree in the sense that the risk is mitigated with diversification and so on top of the benefits that Kirk mentioned with, you know the ability to kind of reinvest tax-free. You also get diversification from a multi-asset fund. You know that is arguably more important than the… Or at least you know, to me when we’re advising clients is just making sure that they’ve got their portfolio diversified. You know, just having all of your eggs in one basket creates more risk. And so the more different projects, including even potentially more different funds that you’re invested in, potentially depending upon how many projects that, you know, the fund manager is involved in, you know, could create more diversification.

And so, I do think and I’m more of a fan of diversification in the mitigation of risk associated with it. But there’s also, you know, as Kirk mentioned, potential tax benefits. You know, with that being said, you know, there is a tax bill coming due in 2026 or potentially later if the legislation passes. And so, you know, I know a lot of people are focused on that as part of the strategy of investing in opportunity funds. And some funds out there are kinda pitching a strategy where they’re looking to refinance once the projects are stabilized and return a good part of the investment to enable the investors to make their tax bill. So, you know, that’s something, I guess it’s probably individually, you know, different from one investor to another, is what your need for the cash flow is. But as Kirk mentioned, if you don’t exactly need the cash flow, including to pay your taxes in 2026, then there are a lot of advantages to having the money roll over inside the opportunity fund structure.

Jimmy: Well, let’s… Go ahead, Kirk.

Kirk: No, I was gonna say, I saw a question from Paul out there and I appreciate Gordon’s comments. Absolutely spot on. Paul asked about, and this is a good question, “If we sell an asset inside the fund, isn’t that going to produce pass-through capital gain to the investors?” And the whole purpose of an opportunity zone fund is a tax-efficient holding. Definitely, you wanna scrutinize and be skeptical about any opportunity to sell. Everything has the right price. If it’s such a great price, do it. When you have a multi-asset fund, you can offset the gains from one asset with the losses generated from another asset. We’re big fans of doing rehab projects and to take advantage of the qualified improvement property or QIP deduction, which generates significant passive losses upfront.

So, if we’ve got 60 million in losses on one project and we sell off half a parking lot from an old Sears, and that generates 5 million in capital gain, these are true facts of what we’ve done. You know, I don’t worry about burning 5 million of the 60 million losses, to generate a return of capital of 100% of the capital from buying a big, huge, vacant empty Sears with 14 acres, selling off half of it, and getting all of our money back. Even if it burns through some of the passive losses, it’s a good deal because it allows us to recycle all of the money that went to that Sears project while we still own it and operate it. And doesn’t trigger any net taxable event out to the investor. Just burns through some passive losses that we’ve accumulated through QIP, which for those who don’t know, allows you to write off this year, 100% of the improvements on the interior space of an existing building used for non-residential purposes. Which is an incredibly advantageous tax incentive to combine with the opportunity zone fund.

It produces massive passive losses during the early years. Now, right, that’s why we favor rehab projects over new construction right now, but the benefits of QIP are gonna go down unless Congress does something next year. It’s 80%, then 60%, then 40%, then 20%. But right now, rehab projects are significantly tax-advantaged over new construction.

Jimmy: Fantastic. Well, I think you answered Paul’s question. He said, “Good answer.” So, and Paul, thanks for the question. And Paul’s gonna be joining us later today as a panelist, later this afternoon. But Paul, appreciate you being here today. Of course, we’ve only got about six or seven more minutes left. I wanted to talk about fees really quickly, get your thoughts on fees before we see if we can answer a few more of these questions. Gordon, I guess I’ll turn to you first. What should investors be aware of with respect to fees and fee structures? What have you seen as examples of reasonable fees or unreasonable fees?

Gordon: Yeah. It’s hard to say because they have to be kinda taken in the context of the deal and one particular fee may be high on one deal, but if they’ve got a different, one of the other fees is low, then the fee structure might be okay. So, you know, it’s a little dangerous to throw out there that, you know, you should look for fees in this range or that range because you have to kinda look at all the fees. But, you know, typically there’d be some sort of fee that would be taken upfront for putting the deal together, you know, like syndication fee or whatever you might want to call it. There’s typically an annual fee for managing, you know, the investments.

And there’s typically some sort of backend, you know, fee or cash-flow related fee that’s tied to, you know, a carried interest. Where the, you know, people that are putting the deal together are getting a piece of the cash flow, both operating cash flow, and the sale. And those carried interests typically are often tiered where that there’s… Once the cash investors hit a certain rate of return, then the interest that the carried group, you know, gets goes up and there might be different tiers of that. So, you know, I think just in general, just being aware of those different tiers of fees and, you know, and paying attention to, particularly if you’re looking at multiple funds. Comparing those fees from one fund to the other to see how they compare, relative to the other funds that you’re looking at investing in.

Jimmy: And Kirk, yeah a good answer there, Gordon, good thoughts. Kirk, go ahead, jump in.

Kirk: Fantastic response, Gordon. Totally. Some examples of some fees you asked, like what are some of the egregious fees? One very common way that sponsors make money on these funds that is not so easy to spot is on the development fees. Which, if you have a fund structure where the fund sponsor is also affiliated with the actual project developer, there are fees down below at the QOZB level that aren’t always disclosed in the PPM because they don’t relate to the fund fees. But those are fees that the sponsor can have an affiliated entity down below that they’re still making money on. So, the fund fees may be low, but if the fees down below at the projects are high, that can still mess up the deal. And if you have high fees at both levels, then it’s really a bad deal.

We saw a good deal that had an affiliated developer down below, and as Gordon mentioned, the waterfalls or the carried interests are often tiered. It went to a 50/50 split at the project level at the QOZB level to the developer entity of which half was owned by the same group that put the fund together. It went to 50/50 split down below, if the IRAs were above 15%, and then it had the same waterfall structure up at the top level at the fund level. So, you had this real asymmetric, risk-return situation, where even if the asset completed a home run, half of the cash flow got siphoned off down below, and then what was left over went up to the fund. And if that was still a home run, half of that got siphoned off again.

And so the investors, even if they backed something that hit a home run, weren’t really benefiting from all of the upsides. Conversely, if it tanked, they had all the, you know, capital at risk. So, the hidden fees are the ones that are really hard to find and hard to know about, but they’re down below at the QOZB level. If you have an affiliated developer, those are not arm’s-length negotiated contracts often. Sometimes they are very reasonable and fair, they’re not all bad, but sometimes there’s some real, you know, ways to slip things in. The other thing that I don’t like, somebody earlier today alluded to that, you know, like a crystallization event. Most of these merchant developers are used to holding for just three to five years then selling, and getting their back ends carried there. With the opportunity zone fund, they’re not gonna sell that quickly most of the time, but they will stabilize and they’ll often adjust the equity in the fund level at that time as if they had sold it for the price that the, you know, it’s valued at when they put on the permanent debt. And you know, so that’s a way to shift equity away from investors and towards the fund sponsors. And we don’t like that. So, those are my comments on fees. Be careful and…

Gordon: Yeah. One other quick point I just wanna make too is with a diversified fund, you do get the benefit of, you know, as compared to like multiple individual project funds of netting basically. So, if you invested in five different projects and three are, you know, home runs and two are duds, you know, you’re gonna pay the full fees on the three that are home runs. But if all five of those are in one fund, they’re gonna be netted and so you’re gonna be paying less fees in a more diversified portfolio. So, that’s another advantage of the diversified portfolio.

Jimmy: Perfect. Well, we’re nearly out of time. I did wanna see if we can get to one or two of these questions we have though. Darrell asks, “Can you explain the Super Roth aspect of opportunity zone investment?” Maybe you can go into a little more detail on what you meant by that, Kirk.

Kirk: Certainly. When you hold real estate inside of an opportunity zone fund, your holdings will appreciate completely tax-free assuming you follow the rules which are at least 10 years but can go out as long as 25 years. And one thing that is significantly better than 10 years of tax-free growth is 20 years of tax-free growth and 25 is even better. And the curve gets logarithmic the farther you run it out. And so, that’s part of the Roth IRA is if you have a Roth IRA and you own it for 5 years and you hit age 59 and-a-half, you can cash out your Roth IRA completely tax-free. Nobody does that, unless they absolutely, desperately need the cash. The same is true here, 10 years is the bare minimum timeframe under the tax code that you need to hold your interest in the opportunity zone fund in order to cash out completely tax-free.

But if you do not need the cash flow and you’re going to own real estate as part of your portfolio anyway, you should keep it inside the tax shelter and have it compound on itself. Every opportunity zone fund that recycles money, is like planting an extra row of crops. It’s like you take your capital gain today, you put it into the fund, you buy a few projects, those things get built out, leased up, stabilize. And for most of them in our structure, we would suggest cash-out refi rather than sell. But either way, money comes back from the project to the fund. At the fund level, it can go… You have 12 months, you have enormous flexibility to figure this out at the fund level under the final regs. You have 12 months to find the next row of crops, the next projects to plant the first harvest back into, and now you have your initial row of crops if you refi them, those first row projects and a second row of projects from the proceeds that you put it in and now you have even more assets that are going to appreciate.

In addition, you get the benefit of the depreciation deductions as long as you have qualified non-recourse financing on the projects. That gives you basis, that is gonna generate depreciation deductions and you’re gonna get the benefit of the depreciation deductions no matter who you are. If you are an investor who rolls over capital gain from the sale of a passive activity like real estate like, if you’re considering a 1031 exchange or this, you can do this and take that capital gain and roll it into your opportunity zone fund. That capital gain comes back as passive income capital gain on your 2026 return. The passive losses that are generated between now and then, which you get the benefit of if you have basis from qualified non-recourse financing, those losses will roll forward until 2026 and offset the gain that comes back in 2026. So, an investor who does a lot of rehab projects and rolls over gain from the sale of a passive activity like real estate, probably won’t pay much or any tax on 2026 return anyway.

So, that’s why we like the rehab approach. That’s why we like recycling because we’re getting more and more assets that are giving us more and more basis, more and more free depreciation deductions. We don’t play depreciation with capture on and all of them grow tax-free, not just for 10 years, but for 20, 25 years. How many times have you heard a story of somebody owning a real estate asset for 20-plus years and having a significant loss on it? Nobody hears that story. But how many times have you heard a story that somebody owned a real estate asset for 20-plus years and had an enormous gain on? That’s what this does, is it allows you to own real estate for 20-plus years completely tax-free. There’s nothing else like it.

Jimmy: Yeah. Well, thanks for that. That’s a great answer, Kirk. Chris Knoppe is up next with CBUS OZ Fund and I’m gonna get to you, Chris, in one more moment here. But Gordon, shut us down quick, 30 seconds to answer this question if you don’t mind, “How do you deal with current income generated in a QOF?” I wanna make sure we got that question answered.

Gordon: Yeah, well that’s taxable. I mean, that’s something you just can’t avoid to the extent that there are, you know, taxable income. Now cash flow doesn’t necessarily translate to taxable income because you’ve got depreciation. And so, but to the extent there is taxable income either from operating a property or a business or from a sale of an asset, that’s taxable during the 10-year period. Now the sale of the asset after 10 years is not taxable. But otherwise, all of that’s taxable and you know, the only really way to deal with it is to shelter it with, you know, losses either from other assets owned by the fund or other investments that you have individually.

Jimmy: Perfect. Well, we’ve run outta time. We have got a lot more questions. I did put links for everyone to learn more and get in touch with Kirk and Gordon in the chat. So, if you’d like to reach out to Kirk or Gordon, you can follow those links and get in touch with these two. Kirk, thank you for joining me today. And Gordon, thank you for joining me today. Appreciate both of your time. Thank you so much.


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