QOZ Investors: Preparing for Deferred Gain Recognition on December 31, 2026

Tax Planning Considerations for Qualified Opportunity Zone Investors

Qualified Opportunity Zone (QOZ) investors are approaching a significant tax milestone. For many pre-2027 Qualified Opportunity Fund (QOF) investments, the original deferral period ends on December 31, 2026, meaning investors may need to recognize previously deferred capital gain even if they continue to hold their QOF investment.

General Rule Under IRC § 1400Z-2

Under IRC § 1400Z-2, taxpayers that timely reinvested eligible capital gains into a QOF generally were permitted to defer recognition of those gains until the earlier of an inclusion event, such as a sale or exchange of the QOF investment, or December 31, 2026. If no earlier inclusion event has occurred, the deferred gain must generally be included in gross income in the tax year that includes December 31, 2026.

For a pre-2027 QOF investment held on December 31, 2026, the amount generally included is the excess of:

1. The lesser of:

• • the investor’s remaining deferred gain, or

• • the fair market value (FMV) of the qualifying QOF investment on December 31, 2026; over

1. The investor’s basis in the QOF investment, taking into account only the statutory basis increases available for five- and seven-year holding periods.

As a result, FMV can be an important factor for investors in underperforming QOF investments. Where the value of a QOF investment has declined, the general rule may reduce the amount of deferred gain required to be recognized in 2026.

Special Rule for QOF Partnerships and S Corporations

Investors holding interests in QOFs organized as partnerships or S corporations are subject to a special rule under Reg. § 1.1400Z2(b)-1(e)(4). For these passthrough QOF interests held on December 31, 2026, the amount included in gross income is the lesser of:

1. The investor’s remaining deferred gain, reduced by any applicable five- or seven-year basis step-up; or

1. The gain the investor would recognize on a fully taxable disposition of the QOF partnership or S corporation interest for FMV.

This rule can produce a different result than the general FMV-based formula because it looks to the gain that would arise on a hypothetical taxable sale of the passthrough interest, not simply the net FMV of the investment.

Why Leverage Can Change the Result

Leverage can materially affect the 2026 gain inclusion calculation for QOF partnerships. For example, if a QOF partnership borrowed funds and either allocated losses and/or made distributions to partners with sufficient debt basis, an investors outside basis may be affected by allocations of partnership liabilities, losses, and distributions. On a hypothetical sale of the partnership interest, the investor’s amount realized may include relief from the investor’s share of partnership liabilities.

Accordingly, even where the net FMV of a QOF partnership interest has declined significantly, the hypothetical taxable sale calculation may still generate gain, resulting from previous loss allocations or distributions received. In that case, the investor may continue to be better off recognizing the originally deferred gain on December 31, 2026, rather than relying on the hypothetical disposition rule.

Planning and Documentation Considerations

QOF investors and sponsors of QOF entities should begin preparing now for the December 31, 2026 inclusion event. Key considerations include:

• Modeling the expected gain inclusion. Investors should estimate the deferred gain recognition under the applicable rule, including any available five- or seven-year basis increases.

• Identifying passthrough-specific issues. Investors in QOF partnerships or S corporations should analyze the special rule under Reg. § 1.1400Z2(b)-1(e)(4), particularly where leverage, distributions, liability allocations, or loss allocations have occurred.

• Substantiating FMV. Because FMV may directly affect the amount of gain recognized, investors should maintain support for the valuation methodology, assumptions, inputs, and any discounts applied.

• Considering third-party valuation. Where an investor expects to rely on a lower FMV to reduce the 2026 inclusion amount, a third-party valuation study may help support the reported position.

• Preserving long-term QOZ benefits. Recognition of deferred gain on December 31, 2026 does not necessarily end the investment’s QOZ significance. Taxpayers that continue to hold a qualifying investment may remain potentially eligible for the 10-year FMV basis election on a later sale or exchange, subject to the applicable requirements.
• Be prepared for investors to have significant liquidity needs in 2026 and 2027 as tax liabilities resulting from QOF gain inclusion come due.

With the end of the deferral period approaching, QOF investors should coordinate with their tax advisers to evaluate the expected 2026 tax impact, confirm the applicable calculation method, and assemble valuation and basis documentation before year-end. Contact your Keiter Opportunity Adviser to learn more.