Navigating the New QOZ Landscape: IRS Notice 2026-40 Explained

On June 18, 2026, the Department of the Treasury and the Internal Revenue Service released Notice 2026-40 (the “Notice”), announcing their intent to issue proposed regulations regarding qualified opportunity zones (“QOZ”) under Sections 1400Z-1 and 1400Z-2 of the Internal Revenue Code of 1986 (the “Code”), as amended by the One Big Beautiful Bill Act of 2025 (the “OBBBA”). The Notice provides transitional guidance on existing qualified opportunity fund (“QOF”) investments, rules governing new post-2026 investments in QOFs, and transitional relief for QOFs and qualified opportunity zone businesses (“QOZBs”) operating in previously designated QOZs. The Notice also confirms that existing QOF investors must recognize remaining deferred gain on December 31, 2026, while providing a framework for continued investment and compliance under the revised statutory regime.

Background

The QOZ program was established by the Tax Cuts and Jobs Act of 2017 to encourage investment in economically distressed communities. In general, the program allows taxpayers to defer—and, after a sufficient holding period, potentially eliminate—U.S. federal income tax on capital gains that are reinvested through QOFs, which are investment vehicles that hold at least 90% of their assets in qualified opportunity zone property and meet certain other requirements, into designated communities. Under prior versions of Sections 1400Z-1 and 1400Z-2 of the Code, taxpayers could defer recognition of eligible capital gains until December 31, 2026, by timely investing corresponding amounts in a QOF. Investors who hold such QOF investments for at least 10 years may elect under Section 1400Z-2(c) to adjust the basis of their qualifying investment to fair market value upon disposition, effectively eliminating gain on appreciation.

The QOZ designations made in 2018 are scheduled to expire on December 31, 2028. The OBBBA substantially revised the QOZ program by making the program permanent (rather than allowing gain to be deferred only up to a single fixed cutoff date), replacing the original fixed reference date of December 31, 2017, (the commencement date of the original program) with an “applicable start date” that instead runs from each new round of QOZ designations (occurring every 10 years), and providing that, for investments made after 2026, each investor’s deferred gain becomes taxable five years after its investment is made (rather than on the single fixed date). The OBBBA also added a potential 30% basis increase for investments in a “qualified rural opportunity fund” (as opposed to the up to 10% basis increase for regular QOF investments).

Notice 2026-40

QOZ Designations Under the OBBBA

Under Section 1400Z-1, each state’s governor nominates eligible low-income community (“LIC”) census tracts for designation as QOZs, up to a maximum of 25% of those communities in the state. The OBBBA amended the 25% limit so that the limit applies to designations “during any period.” The Notice interprets “during any period” to mean each QOZ designation period under Section 1400Z-1. Accordingly, previously designated QOZs do not count against a state’s nomination limit for each new QOZ designation period. For the QOZs that will be designated during 2026, the QOZ designation period begins January 1, 2027, and ends December 31, 2036.

Pre-2027 Investments

For taxpayers with current investments in QOFs, any remaining deferred gain must be recognized in the taxpayer’s taxable year that includes December 31, 2026 (unless an earlier inclusion event occurs). The Notice provides that this gain cannot be re-deferred into a new QOF investment because the original Section 1400Z-2(a) deferral election remains in effect with respect to the underlying eligible gain; as a result, the deemed included gain is not itself “eligible gain” that may be deferred anew. This December 31, 2026 inclusion is not itself a disposition; however, a taxpayer who continues to hold the QOF investment may still elect to adjust the basis of that investment to its fair market value upon a later disposition (thereby eliminating U.S. federal income tax on any appreciation occurring after the date of the investment), provided the taxpayer satisfies the 10-year holding period and certain other requirements as of the date of disposition.

Eligibility of Inclusion Event Gain for Re-Deferral

The Notice clarifies that, unlike the mandatory December 31, 2026 inclusion discussed above—where the taxpayer keeps the qualifying investment such that the gain is not “eligible gain”—an “inclusion event” terminates the qualifying investment, so the recognized gain may be eligible for deferral if the taxpayer makes a new qualifying investment within 180 days of the inclusion event date and satisfies all requirements of Section 1400Z-2(a)(1). However, the original qualifying investment that triggered the inclusion event loses its status as a qualifying investment. As a result, that investment—though it may continue to be held—is no longer eligible for the fair-market-value basis election upon a future disposition.

Tangible Property of QOFs and QOZBs

The OBBBA replaced the requirement that qualified opportunity zone business property (“QOZBP”) be acquired “by purchase” after December 31, 2017, with a requirement that such property be acquired after the “applicable start date” of the relevant QOZ designation period. Because the initial QOZs were designated before the OBBBA’s enactment, they have no “applicable start date” under Section 1400Z-1. To rectify this, the Notice provides that tangible property acquired by an existing QOF or QOZB after December 31, 2026, can qualify as QOZBP if one of the following transition exceptions applies:

• Working Capital Safe Harbor: Tangible property acquired after December 31, 2026, for use in a previously designated QOZ may satisfy the QOZBP acquisition requirement if acquired under a qualifying written working capital plan adopted on or before December 31, 2026, provided: (i) the relevant acquisitions are made substantially consistent with the plan, (ii) the QOZB has received at least 10% of the total estimated working capital assets designated in the plan by December 31, 2026, and (iii) the QOZB has expended at least 5% of the total estimated working capital assets by December 31, 2026. Amounts required to be expended under a binding agreement entered into before January 1, 2027, count toward the 5% expenditure requirement. The Notice extends comparable relief to qualifying equity: stock or a partnership interest in a QOZB acquired after December 31, 2026, pursuant to such a written plan is treated as acquired after the QOZ’s “applicable date,” allowing a QOF to continue making qualifying investments in the QOZB after 2026.
• Ordinary Course Exception: Tangible property acquired after December 31, 2026, by a QOF or QOZB for use in a previously designated QOZ in the ordinary course of its trade or business to replace existing tangible business property may be treated as QOZBP, provided the other requirements of Section 1400Z-2(d)(2)(D) are met. This exception covers replacement or modernization of property necessary to continue the existing trade or business but does not extend to property acquired for expansion or for a transition into a new trade or business.

Post-Expiration Compliance Safe Harbors

Because prior QOZ designations will generally expire on December 31, 2028, the Notice provides safe harbors allowing continued compliance after expiration:

• Substantial Use of QOZBP: To count as QOZBP, tangible property generally must be used within a QOZ, and once a QOZ designation expires such property may no longer so qualify. Under this safe harbor, a QOF or QOZB that acquired the property before its QOZ’s designation expired (or under the working capital or ordinary-course exceptions above) may keep treating that location as if it were still a QOZ for purposes of this requirement only, through December 31, 2047.
• QOZB Gross-Income and Intangible-Property Tests: A QOZB that began the active conduct of a trade or business in a previously designated QOZ before expiration (or reasonably anticipates doing so under a qualifying written plan) may continue to treat the expired QOZ as a QOZ solely for purposes of the gross-income and intangible-property tests under Section 1400Z-2(d)(3)(A)(ii) through December 31, 2047.

Implications

For investors in existing QOFs, the most immediate implication is planning for the mandatory gain inclusion: the Notice confirms that remaining deferred gain becomes taxable on December 31, 2026—even for an investor who does not sell—and that this deemed included gain cannot be rolled into a new QOF to begin a fresh deferral. QOF investors who continue to hold their qualifying investments and satisfy the 10-year holding period may still access the fair-market-value basis election upon a future disposition. Going forward, because the OBBBA made the program permanent, investors also retain a continuing avenue to defer newly realized gains, with a rolling five-year deferral and a basis step-up of up to 10% (or 30% for investments in a qualified rural opportunity fund).

For operators of QOFs and QOZBs with active operations or development projects in previously designated QOZs, the working capital safe harbor and the ordinary-course replacement exception are the most consequential provisions—and may be the difference between continuing to deploy capital in a legacy zone after 2026 and losing QOF eligibility. QOFs and QOZBs should review existing working capital plans, binding contracts, expenditure records, and acquisition plans to confirm eligibility for these exceptions before December 31, 2026.

Stakeholders with QOF or QOZB operations in previously designated QOZs should consult their tax advisors regarding the application of the Notice to their specific circumstances.

This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.