IRS Releases Notice 2026-40: Transitional Guidance on Qualified Opportunity Zones Under §§ 1400Z-1 and 1400Z-2

The Notice introduces planning opportunities both for QOZs and investors that must be taken before the end of this year, including with respect to the fast-approaching December 31, 2026, deferred gain inclusion date. 

Background

The 2017 Tax Cuts and Jobs Act (2017 TCJA) introduced a new tax incentive provision intended to promote investment in economically distressed communities known as QOZs. Under these rules, investors in the program may achieve three significant tax benefits.

• The deferral of gain on the disposition of property to an unrelated person until the earlier of the date on which the subsequent investment is sold or exchanged, or December 31,2026, so long as the gain is reinvested in a qualified opportunity fund (QOF) within 180 days (or 180 deemed days) of the property’s disposition.

• The elimination of up to 15% of the gain that has been reinvested in a QOF provided that certain holding period requirements are met.

• The potential elimination of tax on gains associated with the appreciation in the value of a QOF provided that the investment in the QOF is held for at least 10 years.

The One, Big, Beautiful Bill Act (OBBBA), enacted in July 2025, includes provisions that establish a “second tranche” for the QOZ and QOF programs beginning on January 1, 2027. This “second tranche” picks up following the conclusion of the initial program on December 31, 2026, which marks the end of the inaugural program’s investment period and the date when deferred gain is recognized under the 2017 TCJA. The OBBBA did not, however, include transitional rules designed to address the interaction between the first and second tranches. The Notice is designed to fill in that gap.

Rev. Proc. 2026-14

The IRS previously released Rev. Proc. 2026-14 which prescribed the rules under which the governor of each state, or the chief executive officers of the District of Columbia and the US territories, may nominate tracts for designations as a QOZ and for the US Department of the Treasury to formally designate such QOZ nominations. For an in-depth discussion of Rev. Proc. 2026-14, please see our previously published article, IRS Releases Rev. Proc. 2026-14 – A New Roadmap for ‘OZ 2.0’ Designations.

Transitional Guidance Regarding Section 1400Z-1 

Application of 25% Limitation

The Notice confirms that for the QOZ designation period beginning January 1, 2027, previously designated QOZs do not count against the 25% limitation. 

Applicable Start Date and Designation Period

The Notice clarifies that the term “applicable start date” under § 1400Z-1 means, with respect to any QOZ designated under § 1400Z-1, the January 1 that follows the date on which such QOZ was certified and designated. Thus, with respect to each QOZ certified and designated under § 1400Z-1(b) during 2026, the QOZ designation period begins on January 1, 2027, and ends on December 31, 2036.

Transitional Guidance for Investors 

Gains Realized and Invested in a QOF On or Before December 31, 2026

A key takeaway from the Notice is confirmation that for gains realized and invested in a QOF on or before December 31, 2026, the existing 180-investment rule continues to apply, but any deferred gain must be included in income no later than the taxable year that includes December 31, 2026, unless an earlier inclusion event occurred. Notwithstanding, the taxpayer continues to hold a qualifying investment for which the original election to defer remains in place. Accordingly, the deemed included gain cannot itself be treated as newly eligible gain for a second deferral election under either version of § 1400Z-2(a).

In addition, a taxpayer who recognizes deemed included gain on December 31, 2026, may still be eligible for the § 1400Z-2(c) election on a later sale or exchange of the qualifying investment, provided the taxpayer satisfies the 10-year holding period and other applicable requirements.

Gains Realized On or Before December 31, 2026, and Invested in a QOF on or after January 1, 2027

For post-2026 QOF investments, deferred gain is included at the earliest of (1) a sale or exchange of a qualifying investment, (2) another inclusion event, or (3) five years after the qualifying investment date. 

If the investment is held for at least five years, a taxpayer’s basis in the qualifying investment automatically increases by 10% (or 30%, if the investment is in a qualified rural opportunity fund as defined in § 1400Z-2(b)(2)(C)). 

This five-year period relates back to the date of each investment and permits the investor to plan for when the deferred gain will be recognized as income. For example, if an investor makes a qualifying investment on May 1, 2027, the investor will recognize gain on May 1, 2032 (provided there is no earlier sale or inclusion event). If the investor makes a second qualifying investment the following year on February 1, 2028, any deferred gain will be recognized on February 1, 2033. 

Eligibility of Inclusion Event Gain

The Notice further addresses “inclusion event gains” by directing that such gain may be eligible for deferral under § 1400Z-2(a)(1) if the requirements for a deferral election under § 1400Z-2(a)(1)(A) are satisfied. The taxpayer would treat the gain as if it were recognized upon the occurrence of an inclusion event and not on the sale or exchange that initially gave rise to the eligible gain to which the inclusion event relates. 

To defer such inclusion event gain, the taxpayer must make a qualifying investment within 180 days of the inclusion event. The portion of the original qualifying investment affected by the inclusion event, however, is no longer eligible for the § 1400Z-2(c) election.

Inclusion event gains can be triggered by a gift of a QOF interest other than to a grantor trust (e.g., an outright gift to a spouse) or through a transfer of a QOF interest to a C corporation or S corporation that would otherwise be tax free under § 351. This option is, therefore, presented to all taxpayers who may wish to avoid the December 31, 2026, deemed included gain if they are willing to forgo the exclusion of appreciation from gross income following a 10-year holding period for the QOF interest.

The Notice does not address whether anti-abuse provisions would apply to preclude a subsequent rollover, in particular for those situations where the inclusion event is self-triggered.

Transitional Guidance for QOFs and QOZBs

The Notice focuses primarily on tangible property that is acquired as of January 1, 2027. Specifically, tangible property purchased by a QOF or a qualified opportunity zone business (QOZB) for use in a prior designated QOZ that is not redesignated in the 2027 cycle will generally not be qualified opportunity zone business property (QOZBP) unless it qualifies for one of two exceptions: (1) property acquired post-2026 pursuant to a working capital safe harbor plan for use in a previously designated QOZ, or (2) ordinary-course replacement or modernization property acquired post-2026, for use in a previously designated QOZ. 

Working Capital Plan Exception

To qualify, the working capital plan must have been adopted on or before December 31, 2026, the acquisitions must be substantially consistent with the plan, the QOZB must have received at least 10% of the total estimated working capital assets designated in the written plan by December 31, 2026, and expended at least 5% of those designated working capital assets by that date. Any amounts required to be spent under a binding agreement entered into before January 1, 2027, count toward the 5% expenditure requirement. 

Finally, stock or partnership interests that are acquired pursuant to a written plan post-2026 are likewise treated as acquired after the “applicable date” for purposes of §§ 1400Z-2(d)(2)(B)(i)(I) and 1400Z-2(d)(2)(C)(i).

Ordinary-Course Replacement or Modernization Property

The second transition exception applies to ordinary-course replacement property acquired post-2026 and used in a previously designated QOZ. Replacement or modernization property needed to continue an existing trade or business generally qualifies, but property acquired to expand a business or transition into a new business would not qualify under this exception. The Notice includes illustrations for applying these rules to assist taxpayers.

Compliance Tests After a QOZ Designation Period Ends

The forthcoming regulations are expected to include various safe harbors allowing QOFs and QOZBs to continue satisfying certain QOZ location-based requirements after a previously designated QOZ’s designation expires. 

Substantially all (which generally means 70% per the final QOZ regulations from 2020) of the use of the tangible property must be in a QOZ for substantially all of the entity’s holding period for such property for it to qualify as QOZBP. Further, for an entity to qualify as a QOZB, (1) at least 50% of its gross income must be derived from, and (2) a substantial portion of its intangible property must be used in, the active conduct of a trade or business in a QOZ.

For tangible property otherwise qualifying as a QOZBP and acquired (1) before the relevant designation period expires, or (2) pursuant to one of the two exceptions, the now-expired QOZ may continue to be treated as a QOZ solely for purposes of the substantial-use requirement through December 31, 2047. 

Similarly, a QOZB that is (1) already conducting business in a previously designated QOZ before the designation expired, or (2) that reasonably anticipates doing so under a qualifying written plan, may continue treating the expired QOZ as a QOZ for the relevant gross-income and intangible-property tests through December 31, 2047.

Conclusion

The Notice provides a roadmap for moving from the original QOZ regime under the 2017 TCJA to the upcoming OBBBA-amended regime. The key takeaways for taxpayers are that prior QOZ designations do not count against the new 2027 designation-period cap, investors cannot re-defer deemed included gain recognized on December 31, 2026 (unless the taxpayer triggers an inclusion event prior to December 31, 2026), post-2026 QOF investments receive a new five-year inclusion framework, and QOFs or QOZBs receive limited transition relief for certain property and compliance tests tied to previously designated QOZs.

Overall, the Notice is significant because it preserves continuity for many existing QOZ structures while setting the terms for the next generation of opportunity zone investments. Taxpayers and fund sponsors alike should review existing investments, working capital plans, anticipated property acquisitions, and compliance testing procedures in anticipation of January 2027, because the Notice makes clear that the availability of transition relief often depends on facts and actions occurring on or before December 31, 2026.