Managing 2026 Income Taxes on Qualified Opportunity Zone Fund Investments

Taxpayers holding Qualified Opportunity Fund (QOF) investments should consider planning now to manage the effect of the taxable income inclusion coming at the end of 2026 when the deferred gain from the investments must be recognized. 

The mandatory recognition event could generate sizable income inclusions that significantly increase tax liability and affect other tax calculations. However, there may be opportunities to mitigate the impact of mandatory recognition through harvesting losses, leveraging deductions, or using other deferral options.

QOF Rules

One of the major income tax benefits that arose out of the Tax Cuts and Jobs Act of 2017 (TCJA) was the introduction of Qualified Opportunity Zones (QOZs), underfunded, low-income communities that became designated opportunity zones through state nominations, which were then ratified by the secretary of the Treasury. Beginning in 2018, taxpayers could elect to defer eligible capital gains into a partnership or corporation that qualified as a QOF, a special purpose entity established to facilitate the acquisition and development of qualifying real property and business assets located in QOZs.   

The TCJA provided three QOZ tax benefits:

1. Deferral of Eligible Capital Gains – Taxpayers who made a QOF investment on or after January 1, 2018, were permitted to defer capital gain.  The original deferral period for those investments ends -- and all deferred gains must be recognized -- on December 31, 2026;
2. Permanent Reduction of Eligible Deferred Gain - Investors who deferred gains into a QOF prior to 2022 can enjoy a 10% reduction of that gain if they held the QOF investment during the deferral period for a minimum of five years, and an additional 5% reduction if the investment was held for seven years. To qualify, investors must meet these holding period requirements within the deferral period ending on December 31, 2026; and
3. Permanent Exclusion of Appreciation Gains - Upon the sale of either their interest in a QOF or of the underlying QOZ business property, taxpayers who hold the investment for at least 10 years can elect to step up their tax basis to its fair market value (FMV), resulting in no income tax on the accumulated appreciation associated with their qualified QOZ investment.   

How to Determine QOZ Capital Gain

The amount of gain recognized equals the difference between the investor’s adjusted tax basis in the original investment (generally zero unless deferred gain has already been recognized in an inclusion event) and the lesser of:

• The amount of eligible gain originally deferred, minus the 10% and 5% permanent reductions, if applicable; or 
• The QOF investment’s FMV as of December 31, 2026. 
  
  

According to the QOZ tax rules:

• The QOZ gains recognized at the end of 2026 retain the character -- long-term or short-term -- of the transaction from which they originated; and
• The tax rate is the applicable rate for tax year 2026.
  
  

Tax Planning Considerations

Investors holding qualified investments in QOFs should consider the following approaches to mitigate exposure to income taxes related to a gain deferral recognition event:

• Harvesting 2026 capital losses held in their securities and/or business asset portfolios; 
• Conducting cost segregation studies of completed buildings and developed business assets to accelerate related tax deductions in 2026;
• Utilizing the tax deduction enhancements introduced by the One Big Beautiful Bill Act (OBBBA) for:
  • Qualified production property deductions;
  • Reinstated 100% bonus depreciation; and
  • Various tax credits available for 2026.
• Deducting accumulated suspended tax losses held in the QOF investment portfolio.  These are related to deferral period allocations of operating losses from QOF partnerships and S corporations that may have been suspended due to outside tax basis limitations during the deferral period;  
• Substantiating a reduced FMV in the QOF investment. The deferred gain recognized at the mandatory recognition date is limited to the QOF’s FMV, so investments that have diminished in value could result in a reduced tax liability. But taxpayers will need to support a claim of reduced FMV with a credible valuation, which will require an independent appraisal. Investors should evaluate the cost of documenting a reduced FMV compared to the potential tax benefit associated with this planning item; and
• Completing a sale or exchange of a QOF investment or underlying QOZ property before the mandatory recognition date and re-deferring the gain into another QOF investment. The IRS regulations allow taxpayers who recognize eligible deferred gain resulting from an inclusion event to re-defer that gain into another QOF investment. This may be particularly attractive for underperforming investments that could be reinvested in a more promising QOF. The OBBBA extended and modified the QOZ program so that it will be available for investments after 2026. Taxpayers generally have 180 days from closing a transaction that gives rise to eligible gain to make a QOF investment. Alternative investment periods are available for eligible gains reported on Forms K-1 and installment sale gains. Thus, there may be opportunities to reinvest 2026 gains in 2027 and be eligible for five additional years of deferral and a basis increase of up to 10%.  

State Income Taxes

Most states adopted and conformed to the federal QOZ rules at the state level, requiring QOF investors to recognize state-level QOZ income at the end of 2026.  

Impact on Estimated Tax Payments

Because the deferred capital gains become taxable on December 31, 2026, associated estimated income tax payments may be delayed as far as the extension date for 2026 tax returns.