The Tax Cuts and Jobs Act created a new kind of investment vehicle, Qualified Opportunity Zone Funds. To increase investment into economically depressed areas, these investments offer taxpayers both a temporary deferral of capital gains as well as the potential for a permanent exclusion of future gains.
Under the TCJA rules, a taxpayer with eligible gain (any capital gain, not including §1245 or §1250 recapture) could defer recognition of that gain until the earlier of the year in which they had an inclusion event related to that gain, or December 31, 2026. There are several events that could trigger gain inclusion such as a sale or disposition of the investment or gifting the investment to another individual. The gain is included on the taxpayer’s return at the end of the deferral period whether they sell the investment or not.
When TCJA created the program, there was one designation of qualifying zones, and that was it for the QOZ deferrals. But then, the One Big Beautiful Bill (OB3) Act revived the program, making it permanent and creating rolling designation periods. Under the new rules, taxpayers may defer gain until the earlier of the year in which they have an inclusion event, or five years from the date of the deferral.
Under both the TCJA and OB3 rules, the initial gain deferral is temporary, and at some point the taxpayer has to pay the piper.
But then the fun really starts.
After the gain inclusion, if the taxpayer continues to hold the investment and owns the investment for at least 10 years, when they ultimately sell their interest in the Opportunity Zone they can elect to adjust the basis to the fair market value on the date of the sale. What does this mean? It means that no matter how much the investment goes up in value after the inclusion event, after year 10 you can exclude all the federal gain. Taxpayers with TCJA QOZ investments can make that basis election as far out into the future as they want. OB3 QOZs are capped at 30 years of appreciation. After year 30, the basis is locked.
So, while the temporary deferral can be a nice planning tool, and is a great trick to have handy if a 1031 falls through, or if a client shows up with a surprise $1,000,000 gain, the real money is in the potential for long-term gain exclusion.
Double the Fun(d)?
As the inclusion date for TCJA QOZs looms, some creative preparers began wondering if it would be possible to re-defer the gain from the TCJA QOZ into a new OB3 fund without having to sell the investment. There was conflicting guidance, which makes sense when you consider that the program was supposed to end after 2026. The OB3 revival meant that the issue would have to be resolved.
In early July, the IRS issued Notice 2026-40, which offers transitional guidance for the QOZ program, and breaks the hearts of anyone hoping to push that gain recognition further into the future.
The guidance states that a QOZ election cannot be made for gain that already has an election (all of the TCJA gain), and the gain must be included in income on the 2026 return. HOWEVER, a taxpayer could sell part or all of their investment in the fund, and then defer that gain, but if they did this they would lose out on not only the ten-year holding period but also the indefinite FMV adjustment in the future.
To double defer the gain, the taxpayer would have to have this full or partial disposition within the last half of 2026 and wait to reinvest the funds until at least January 1, 2027. It may be safer to wait until late 2026 to allow the taxpayer more time to find a new QOZ in early 2027.
Even though the TCJA version of the program has ended, investors holding TCJA opportunity zones remain eligible to make the basis adjustment when they sell in the future.
Is it better than a 1031?
No.
If a taxpayer wants to defer gain from the sale of business or investment use real property, a §1031 exchange is still the way to go. When a QOZ can be useful is if a taxpayer has gain from any other kind of asset sale that wouldn’t qualify for §1031, or if they were planning to do a §1031 exchange and something went wrong. If the 45-day identification deadline is missed, a QOZ can be a nice thing to have at the ready as a Hail Mary.
State of Deferral
Not all states conform to the tax treatment of Opportunity Zones, so it is important to check the rules in the taxpayer’s state of residence. California, for example, doesn’t conform to the deferral or the exclusion, so there will be timing differences in the income recognition, and potentially large gains that are completed excluded on the federal return but fully taxable to the state.
It is also important to keep an eye on where the zones are located when looking at strategies to minimize state tax.
When Opportunity Knocks
Now that the program is permanent, it’s likely that we will see these investments being used more regularly. Exchanges are already being established to help investors exit their interests in zones, or swap them with other investors, making a very illiquid investment seem perhaps a bit less daunting.
Understanding the tax benefits of investing in Opportunity Zones can create opportunities for short-term planning and long-term savings.