Opportunity Zones

The Qualified Opportunity Zone (QOZ) Program, enacted as part of the TCJA, provides taxpayers with tax-enhanced returns on qualified investments made into designated opportunity zones. The program offers several key benefits, including temporary deferral of eligible gains, a step-up in tax basis for certain investments, and the exclusion of taxable gains for investments held for ten years or more. These tax advantages, combined with sound underlying economics, can significantly enhance the overall attractiveness of an investment opportunity.

Importantly, the gains reinvested and deferred under the program are not deferred indefinitely until the investment is sold or liquidated. Rather, the gain deferral represents only a temporary relief of tax liability. All gains deferred into the first QOZ program will be deemed recognized and taxable as of December 31, 2026.

Accordingly, taxpayers with QOZ investments should ensure that these deferred gains are incorporated into their 2026 tax planning and projections. Advisors — including tax preparers, financial planners, and investment professionals — should be fully informed of the deferred gains scheduled for recognition in 2026. To mitigate the tax impact, taxpayers may be able to offset the recognized capital gains with capital losses realized throughout the 2026 calendar year. Proper coordination and timing can be critical for effective tax management.

Three primary tax benefits available for QOZ investors are:

1. The ability to defer the gain until either the investment was sold or a set date (12/31/2026 under the TCJA)
2. A reduction in the amount of capital gains income from the original sale, provided that the new investment is held for a set period.
3. Permanent exclusion of gain from appreciation on the new investment if held for a set period of time.

The deferral rules for opportunity zones provide opportunities that 1031 exchanges do not. After enactment of the TCJA, only real property is eligible for section 1031 treatment. By contrast, opportunity zones allow deferral of any form of capital gain income, including section 1231 (business asset) sales treated as capital gain income and capital gain from stock sales. Additionally, in the case of a 1031 exchange, all proceeds must be reinvested in the new property, including the return of the original investment basis. In an opportunity zone investment, a taxpayer can simply take the amount of cash equal to the realized capital gain and invest it in the QOZ. Another contrast to 1031 exchanges is that the election to defer the investment in the QOZ is made by the individual members for passthrough capital gains. Notably, the opportunity zone benefits are only available for investments made with capital gain funds. Any additional cash invested is ineligible for the stepped-up basis on the new investment.

It is also important to note that not all states conform to the Federal QOZ provisions. Some states decoupled from the federal rules in later years, meaning that certain taxpayers may have already paid state tax on their deferred gains. In some cases, the same qualified fund investment may have been tax-deferred at the state level in one year but fully taxable in another.

Taxpayers should work closely with their advisors now to confirm state conformity and develop a plan in preparation for their QOZ gains that will be recognized in 2026. Early preparation will allow for cash-flow planning, strategic use of losses, and optimal coordination among advisors to minimize the overall tax burden.

The OBBBA extended the availability of deferring capital gains by investing in qualified opportunity zones and included the following key updates:

Deferral Rules

Under the earlier version of the QOZ rules, a taxpayer was able to defer the gain until the earlier of when the investment was sold or Dec 31, 2026. The basis of the original investment is zero. If the qualifying investment was held for at least five years before 12/31/2026, then the taxpayer’s basis is increased by 10% of the original gain that was deferred. If the qualifying investment was held for at least seven years before 12/31/2026, then the basis is increased by an additional 5% of the original deferred gain (for a total of 15%). If the qualifying investment is held for at least 10 years, then the taxpayer can elect to have the basis equal to the FMV on the date that it is sold. This allows all post-acquisition gains to be excluded from income.

Under the new rules, which begin January 1, 2027, the income from the original sale can be deferred until the earlier of five years after the date of investment or the date on which the investment is sold or exchanged. This replaces the single cut-off date of 12/31/26 with a rolling 5-year deferral. After the investment is held for 5 years, the basis is increased by 10% of the original deferred gain (30% for qualified rural properties). If the property is held for more than 10 but less than 30 years, the taxpayer may elect to treat the basis as the fair market value on the date of sale. If an investment is held for 30 years, the taxpayer can elect to treat the fair market value at the 30-year date of the investment as the basis.

Opportunity Zone Designations

Under the new legislation, determinations of QOZ qualification begin on July 1, 2026, and are redetermined every 10 years on July 1.

Under both the earlier and revised versions of the QOZ rules, there is a limit of 25% of the low-income census tracts to be qualified as opportunity zones (with a minimum of 25 eligible tracts per state if the number of low-income communities is less than 100). Under the TCJA, this limit did not apply to Puerto Rico. Under the OBBBA, the 25% limit is applied to Puerto Rico as well.

The eligibility rules for opportunity zones are modified to be somewhat more restrictive. Under the old rules, to qualify as a low-income community, an area had to have either: (1) a poverty rate of at least 20%, or (2) the median family income does not exceed 80% of the state’s median income. The new rules are somewhat more restrictive requiring that the 20% poverty rate test be accompanied by a limit of 125% of the state median income, and the 80% median income test has been lowered to 70% of state median income. Additionally, the new rules remove the ability to qualify under the contiguous census tracts rule.

Introduction of Rural Opportunity Funds

OBBBA added a new category of Qualified Rural Opportunity Fund, which has unique benefits. As mentioned, when the investment is held for at least 5 years, the taxpayer can exclude 10% of the original capital gain income. If the investment was made in rural funds, the taxpayer can exclude 30% of the gain. Additionally, it lowers the substantial improvement threshold to 50% of the adjusted basis. In general, for property to qualify as opportunity zone business property, it must be either original use property to the opportunity zone business or have improvements that exceed the original cost of the property. Under the new rules, rural properties will meet this threshold if they improve the property by 50% of the adjusted basis.

A rural opportunity fund must hold 90% of its assets in qualified opportunity zone business property, which are entirely in rural areas. Rural areas are places with less than 50,000 inhabitants and are not contiguous and adjacent to areas with 50,000 inhabitants.

The substantial improvement requirement made the opportunity zone rules difficult to meet for businesses that are not capital intensive. The lower threshold in rural funds may enable use of the QOZ program among a more diverse group of businesses.

Expanded Reporting and Disclosure Requirements

The OBBBA adds new IRC Section 6039K, which adds additional information to the required annual filings of the QOZ fund on Form 8996. Some of the new information required to be reported includes the number of employees of the business, the number of residential units in the QOZ business property, and details regarding investors who dispose of their interest in the fund during the year. Another new Section 6039L adds a requirement that the qualified opportunity zone business furnish information to the QOZ fund necessary for it to meet the reporting requirements of 6039K.

In addition to the new reporting requirements, the penalties for noncompliance are increased substantially. Under the new rules, a QOZ Fund can be subject to a penalty for non-filing of $500 per day up to a maximum of $10,000 ($50,000 for large QOZ Funds). In the case of intentional disregard, the penalty is $2,500 per day, up to $50,000 ($250,000 for large QOZ Funds).

The following provides a summary of the OBBBA’s changes as compared to the original program enacted by the TCJA.