Opportunity Zone 1.0 begins expiration process at year-end

Approximately 25,000 distinct investors (21,000 individuals and 4,000 corporate entities) have invested over $100 billion in capital gains in Qualified Opportunity Funds since the program was introduced in 2017. Chances are you have clients, or potential clients, looking for guidance as OZ 1.0 deferrals expire at year-end 2026 and OZ 2.0 begins for investments made on or after Jan. 1, 2027.

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Since “rollovers” generally aren’t permitted, billions of dollars in deferred capital gains will have to be settled up with the government and that’s where you come in. 

Investors in OZ 1.0 have been able to defer paying tax on long-term and short-term capital gains not only from real-estate investments, but from stocks, bonds, crypto, certain business property, installment payments and pass-through gains from partnerships, S corporations and trusts. Investors received a generous 10% basis bump after five years and a complete 100% tax exemption after holding for 10 years. Now the tax “bills” are coming due on these deferred capital gains and you need to help clients prepare for the recognition of these gains on Dec. 31, 2026.

Since the amount reported is generally the lesser of the taxpayer’s deferred gain, or the fair market value of the taxpayer’s OZ assets on Dec. 31, 2026, valuations of both hard assets and partnership interests are essential. Cost segregation studies and loss offsetting strategies may further reduce the 2026 tax hit. 

OZ investors can also deduct any tax basis increase to which they are entitled for holding their OZ investment for at least seven or five years (15% for OZ funding occurring on or before Dec. 31, 2019, or 10% for OZ funding between Jan. 1, 2020, through Dec. 31, 2021). For example, a taxpayer who made a $1 million contribution on Dec. 1, 2019, whose interest has dropped to $700,000 will generally report $550,000 (the $700,000 value less a $150,000 basis increase) (55% of the original deferral). 

Note: The OZ regulations have more complex calculations when the OZ structure includes partnerships or S corps, and debt-financed projects. These regulations have unique and untested fair market value definitions and will likely be challenged in court.

Investors seeking the new “OZ 2.0” benefits should identify eligible 2026 gains, the variety of funding dates depending on the nature of the reported gain and potential OZ 2.0 eligible locations while the new OZ tract maps are taking shape. We expect the final OZ 2.0 census tracts to be available in December, but many states have already made their choices public. It’s worth noting that OZ 2.0 monies can be used in certain cases to complete OZ 1.0 projects or to invest into OZ 2.0 projects. Either way, the OZ 2.0 monies contributed are eligible for the enhanced OZ 2.0 benefits.

Notice 2026-40 provides that property acquired after Dec. 31, 2026, generally will not qualify as Qualified Opportunity Zone Business Property in a previously designated 1.0 Qualified Opportunity Zone, but provides exceptions for property acquired under a qualifying written working-capital safe-harbor plan and for ordinary-course replacement or modernization property. OZ 1.0 projects that are still under development must update their business plans and must ensure that they have contributed at least 10% of the total project funding to the QOZB by year end, as well as expended (or be under a binding contract) at least 5% of the total contract price by year end.  For more, see Ten Things to Know about the IRS’s Recent OZ 1.0 to 2.0 Transition Guidance.

OZ 1.0 allowed taxpayers to defer eligible capital gains by investing them in a QOF by Dec. 31, 2026. The remaining deferred gain generally becomes reportable in 2026 even if the investor continues to hold the fund interest. That required inclusion does not, by itself, end the investment’s potential benefit from a later qualifying sale after a 10-year holding period. 

A Dec. 31, 2026, deferred gain inclusion also cannot simply be reinvested into another QOF to obtain a second OZ deferral. Notice 2026-40 treats a “Deemed Included Gain” as ineligible for a new deferral election, although a separate actual sale, exchange or inclusion event prior to year-end may generate eligible gain for OZ 2.0 reinvestment if the normal requirements are met. Therefore, a de-certification or other inclusion event from an asset sale or liquidation of the OZ structure prior to year-end may allow the related gain to be reinvested into a new OZ fund. 

Clients who’ve invested in QOFs should obtain a supportable year-end valuation of each QOF interest and review their original deferred gain, adjusted basis, prior inclusion events and available basis increases. Valuation discounts require facts and documentation; they should not be assumed from a project’s general financial difficulties.

Losses and deductions

Tax planning should also address losses and deductions in the same tax year. Capital loss carryforwards and current capital losses may offset 2026 capital gains, including the “Deemed Included Gain,” subject to the applicable netting rules. Passive losses may help where the investor has sufficient passive income and the activity rules permit their use to offset a “passive” capital gain; they are not a universal offset for an OZ inclusion.

Available net operating losses, charitable deductions and depreciation from other investments also warrant review under their separate limitations. A coordinated 2026 projection can show both the federal liability and any different state result (since several states do not conform to the federal OZ rules). For more, see this 2026 Opportunity Zone planning alert.

What OZ 2.0 changes

For qualifying QOF investments made beginning Jan. 1, 2027, OZ 2.0 provides a new, rolling deferral period. Deferred gain generally becomes taxable upon an earlier inclusion event or five years after the investment. An investor who meets the five-year holding requirement may receive a 10% basis increase in the deferred gain and the increase may reach 30% for an investment in a qualified rural opportunity fund that meets the statutory requirements. The ability to exclude qualifying appreciation after a sufficiently long holding period remains a central incentive.

For qualifying property in a zone that is entirely in a rural area, the substantial improvement threshold has been reduced from 100% to 50% of the building’s adjusted basis. For example, assume a QOZB acquires an existing rural property for $1 million, and the land is worth $200,000 and the building, hardscape and landscape are worth $800,000. Under OZ 2.0, the fund will only need to improve the building and other property by $400,000 (50% of $800,000) to meet the substantial improvement test over a 30-plus month period. This change already applies to certain qualifying improvements in existing rural zones; investors should separately confirm whether a newly selected tract and the proposed fund satisfy the rules for each OZ 2.0 benefit.

Plan the 180-day investment window

The standard reinvestment rule gives an individual taxpayer 179 days from the event producing an eligible gain to invest up to the corresponding amount into a QOF. You don’t have to invest the full gain like you do with a 1031 exchange. The date of sale is counted in the 180-day rule. Other permitted start dates for capital gain generated through a flowthrough entity can extend the practical decision period. An owner receiving eligible gain through a partnership or other qualifying pass-through entity may, depending on the entity and reporting facts, use the gain date, the entity’s taxable year-end or the unextended due date of its return, which is generally March 15 of the following year. For eligible installment-sale gain, the regulations offer an election tied to the payment date or the last day of the taxable year in which the payment is received.  

These rules can allow certain capital gains realized in 2026 to support a timely QOF investment into 2027 — thereby making them eligible for the more valuable OZ 2.0 treatment. IRS transition guidance expressly permits an otherwise eligible pre-2027 gain to be invested on or after Jan. 1, 2027, if the investment meets the applicable 180-day deadline and the new program’s requirements. The correct start date must be documented for each taxpayer. Neither a late QOF investment nor an artificial change in payment terms creates eligibility. For more, see Extending the OZ Investment Window.With OZ 1.0 deferrals ending Dec. 31, 2026, advisors should act now by securing valuations, offsetting gains and timing new investments to reduce clients’ tax bills and capture OZ 2.0 benefits.

Additional reporting by Abi Yanke, tax manager in the Salt Lake City office of HCVT.