IRS Notice 2026-40 Provides Critical Transition Guidance for Opportunity Zone Investors, Funds and Businesses

June 22, 2026

The IRS has released Notice 2026-40 this week, providing important transitional guidance for Opportunity Zone (OZ) investments and Qualified Opportunity Funds (QOFs) following the enactment of the One Big Beautiful Bill Act (OBBBA). The Notice addresses the transition from the original OZ program (“OZ 1.0”) to the new OZ regime beginning January 1, 2027 (“OZ 2.0”).

For existing OZ investors, fund managers, and operating businesses, several provisions are particularly significant.  Because Notice 2026-40 provides transitional guidance rather than final regulations, certain provisions may be revised as Treasury and the IRS continue the rulemaking process.

Executive Summary

IRS Notice 2026-40 provides much-needed transition guidance as the original OZ program approaches its December 31, 2026, gain recognition date.

The most significant taxpayer-friendly provisions include:

1. Existing investors retain access to the 10-year tax-free appreciation benefit.
2. Pre-2027 gains can still qualify for OZ 2.0 deferral if invested in 2027 within the applicable 180-day period.
3. Gains invested after January 1, 2027, cannot enter an OZ 1.0 project unless that project has a valid Working Capital Safe Harbor (WCSH) plan with at least 10% of planned working capital already received by the QOZB by December 31, 2026.  The common assumption among OZ practitioners that new money could enter OZ 1.0 deals through December 31, 2028 (or later) without restriction, would be modified by this Notice.  See Section 5 below for a full discussion of this important restriction.
4. Inclusion Event gains remain eligible for new OZ reinvestment and potential 5-year deferral under OZ 2.0.
5. Multi-year WCSH projects receive important transition relief.
6. Existing OZ businesses may continue replacing and modernizing property after 2026.
7. Safe harbors extend many QOF and QOZB eligibility and compliance testing through December 31, 2047.

At the same time, the IRS clearly confirms that the mandatory December 31, 2026, gain inclusion cannot itself be deferred through a new OZ investment, making proactive tax planning essential for affected investors.

1. Existing OZ Investors Cannot Reinvest December 31, 2026, Gain Inclusion

Key Takeaway

Many taxpayers had questioned whether the deferred gain recognized on December 31, 2026, could itself be reinvested into a QOF and deferred again.  This is important to note that this guidance relates only to a gain that matures on December 31, 2026.  See Section 2 below regarding inclusion events.

The Notice confirms that the answer is no.

IRS Position

• Investors who defer gain into a QOF prior to December 31, 2026, must recognize the deferred gain on December 31, 2026 (unless previously triggered by an inclusion event).
• The recognized gain is referred to as “deemed included gain.”
• Because the original deferral election remains in effect, the deemed included gain is not eligible gain for a new OZ deferral election.
• Consistent with the Internal Revenue Code (IRC), taxpayers cannot “roll over” the December 31, 2026, inclusion amount into another QOF investment.

Planning Implications

• Investors should plan now for the potential tax liability arising in 2026.
• Cash flow planning becomes increasingly important for investors with large, deferred gains.
• Strategies such as loss harvesting, charitable planning, installment sales, passive loss utilization, and valuation discount planning may deserve consideration before year-end 2026.
• As discussed below, pre-December 31, 2026, inclusion gain may still be available for a secondary rollover.

2. Inclusion Event Gains May Remain Eligible for Reinvestment

Key Takeaway

The IRS apparently preserved an important planning opportunity involving inclusion events.  Inclusion amounts are gains triggered BEFORE December 31, 2026, and examples are provided below.

IRS Position

• Gain recognized because of an inclusion event may itself qualify as eligible gain.
• Investors generally have a new 180-day period beginning on the inclusion event date.
• The gain may be reinvested into a QOF if all other requirements are satisfied.
• Caution: it is unclear whether the IRS might apply their anti-abuse provisions contained in the OZ Regulations to preclude a subsequent rollover.

Planning Implications

• Taxpayers considering this strategy should carefully evaluate the potential application of the OZ anti-abuse rules. The fact that the IRS explicitly raised this possibility, which is supported in existing regulations, is a positive, and the fact that they did not mention any limitations or the Anti-Abuse regulations would seem to green-light this strategy.  However, it is difficult to predict whether the IRS might later attack this fact pattern.
• Taxpayers who have made qualified OZ investments into Qualified Opportunity Zone Property prior to triggering an inclusion event, or shortly thereafter, will be better positioned to support continued tax deferral.
• All OZ investors should keep records of the OZ Funds and OZ properties they have evaluated during their deferral periods.  
• Documenting the clear intent of the taxpayer to satisfy the goal of the statue for wealth generators to invest in under-served communities will improve the taxpayer’s chances of preserving their OZ benefits.

Examples of Potential Inclusion Events

• Certain gifts – even to a spouse.
• Certain partnership distributions.
• Transfers reducing a qualifying investment.
• Distributions in excess of tax basis in the QOF
• A Decertification of the QOF
• Other Inclusion Events described in the OZ regulations.

Planning Opportunity

• This may create a second opportunity to defer gain that otherwise would become taxable because of an inclusion event.  However, extreme caution should be exercised before triggering such a transaction and efforts to minimize the application of anti-abuse attack should be considered.

3. Existing Investors Retain the 10-Year Tax-Free Treatment

Key Takeaway

The IRS confirms that recognition of deferred gain on December 31, 2026, does not eliminate future eligibility for the 10-year basis step-up election.

IRS Position

• Investors who continue to hold their QOF interests after recognizing deferred gain in 2026 still retain a qualifying OZ investment into future years.
• Those investors remain eligible to make the election under IRC §1400Z-2(c) upon a later sale of the QOF investment, assuming all holding period requirements (including the 10-year QOF holding requirement) are satisfied.

Planning Implications

• Existing OZ investors should generally not view 2026 gain recognition as ending the OZ tax benefits.
• The long-term tax-free appreciation benefit remains available.

4. Pre-2027 Gains Can Still Be Deferred Under OZ 2.0

Key Takeaway

One of the most important clarifications in the Notice is that gains realized before 2027 may still qualify for deferral if invested after January 1, 2027, within the applicable 180-day investment period.

IRS Position

• Eligible gains realized before, on, or after December 31, 2026, may qualify for OZ deferral if invested in a QOF after January 1, 2027.
• The investment must still satisfy the applicable 180-day investment period rules.
• The new OZ 2.0 deferral regime applies: 5-year gain deferral, 10% or 30% (rural) basis step-up after 5 years, and 10-year tax-free gains.

Examples

Potentially qualifying gains could include:

• Late-2026 asset sales (post-July 9, 2026).
• K-1-reported gains (e.g., Partnership and S Corporation reported gains where the owners can choose a 180-day period extending into 2027).
• Certain installment sale gains recognized in 2027.
• IRC §1231 gross gains (1231 losses are not required to be netted).
• IRC §1256 gains (calculated for the full year as of December 31 and deemed to be 40% short-term and 60% long-term capital gains).

Planning Opportunity

This guidance creates significant planning opportunities for taxpayers seeking to defer gains into the new OZ 2.0 program beginning January 1, 2027.  See additional details for securing OZ 2.0 treatment for calendar 2026 gains. 

5. New Restriction: Post-2026 Gains Cannot Enter OZ 1.0 Projects Without an Active Working Capital Safe Harbor Plan

Key Takeaway

Notice 2026-40 contains a significant restriction that differs from the interpretation many OZ practitioners previously expected.  Gains invested on or after January 1, 2027 cannot be placed into a previously designated (OZ 1.0) project unless that project is operating under a valid WCSH plan that was adopted on or before December 31, 2026, and at least 10% of the planned working capital has already been received by the QOZB and 5% of the planned working capital has already been expended by the QOZB by that date.  The widespread assumption that new gains could freely enter OZ 1.0 deals through December 31, 2028, is not supported by the Notice.

Background

Prior to Notice 2026-40, many practitioners assumed that OZ 1.0 deals in previously designated census tracts would remain open to new investor capital through at least December 31, 2028, when the original zone designations expire (December 31, 2027, for Puerto Rico tracts).  The Notice makes clear that assumption will not pertain.

The OBBBA amended the definition of Qualified Opportunity Zone Business Property (QOZBP) to require that tangible property be acquired after the “applicable start date,” defined as the January 1 following the date of designation.  Previously designated OZ 1.0 tracts do not have an “applicable start date” under the OBBBA because their designation predated the July 4, 2025, enactment.  As a result, property acquired by a QOF or QOZB in a previously designated zone after December 31, 2026, cannot qualify as QOZBP under the general rule, regardless of whether the zone designation remains technically active through 2028.

IRS Position

Property acquired after December 31, 2026, may continue to qualify as QOZBP in a previously designated OZ 1.0 zone only if all of the following conditions are met by December 31, 2026:

• A formal written WCSH plan must be adopted on or before December 31, 2026, identifying the intended use and expenditure schedule for working capital assets.
• The QOZB must have received at least 10% of the total estimated working capital assets designated in the plan by December 31, 2026.  Cash or property must actually flow to the QOZB level, not merely sit at the QOF.
• At least 5% of total planned working capital assets must have been expended by December 31, 2026.  Amounts committed (even if not yet paid) under binding contracts entered into before January 1, 2027, count as expended for this purpose.
• All property acquisitions after December 31, 2026, must be substantially consistent with the written plan.

Planning Opportunity

On the positive side, a WCSH plan adopted before December 31, 2026, gives the QOZB the full 31-month expenditure window, potentially running through approximately July 2029.  Combined with the post-expiration safe harbors through December 31, 2047, described in Section 8 below, a compliant OZ 1.0 project with an active WCSH plan can:

• Continue to accept new investor capital after January 1, 2027, under the OZ 2.0 deferral rules.
• Acquire qualifying property through July 2029 (31 months from plan adoption).
• Continue to satisfy QOZB compliance tests through December 31, 2047, even after the underlying zone designation expires in 2028.

Planning Implications

OZ 1.0 sponsors who plan to accept investor capital after January 1, 2027, should take the following steps before December 31, 2026:

• Form the QOF and QOZB: OZ 1.0 QOF and QOZB entity formation should be completed well before year-end to allow time to adopt and fund the WCSH plan at the QOZB level.
• Adopt a written WCSH plan: The plan must identify the project’s anticipated working capital needs and a 31-month deployment schedule.
• Fund at least 10% of total planned working capital into the QOZB by December 31, 2026: This is the threshold that keeps the project eligible for post-2026 capital raises.  If capital has not been received at the QOZB level by that date, the WCSH exception is not available.
• Expend or contractually commit at least 5% of estimated working capital before December 31, 2026: Binding construction, development, or purchase contracts executed before January 1, 2027, count as expended for this purpose.

OZ 1.0 fund managers and sponsors who intend to raise capital after January 1, 2027, should treat December 31, 2026, as a hard deadline to have their QOF and QOZB in place, their WCSH plan documented, and the required 10% of project capital funded into the QOZB.

6. New OZ 2.0 Investments Receive a New Five-Year Deferral Period

Key Takeaway

For investments made after December 31, 2026:

• Deferred gain generally remains deferred for five years.
• Gain is recognized upon the earliest of:
• Sale of the investment.
• Another inclusion event; or
• Five years after the QOF investment date.

Additional Benefit

• Investors receive a 10% basis increase after a five-year holding period.
• Qualified Rural Opportunity Funds may qualify for a 30% basis increase vs. the standard 10% increase.

7. Limited Relief for Existing OZ Projects Under Working Capital Safe Harbor Plans

Key Takeaway

Perhaps the most important guidance for sponsors and developers is limited relief for projects that extend beyond December 31, 2026.

Background

Under OZ 2.0, OZ-eligible property generally must be acquired after the applicable start date of newly designated OZ tracts.  This created concern that projects located in original OZ tracts could lose eligibility after 2026.

IRS Relief

Property acquired after December 31, 2026, may continue to qualify if:

• The project is operating under a valid WCSH plan adopted on or before December 31, 2026.
• Property acquisitions are substantially consistent with that plan.
• At least 10% of planned working capital has been received by the QOZB by December 31, 2026.
• At least 5% of planned working capital has been expended (or committed under binding contracts) by December 31, 2026.

Why This Matters

This transition rule protects many:

• Multi-phase real estate developments.
• Manufacturing projects.
• Operating businesses.
• Large-scale OZ developments expected to continue beyond 2026.

Fund managers must take great care in ensuring that they meet the safe-harbor rules, and cash may need to be deployed, and WCSH plans must be updated prior to year-end.

8. Replacement/Improvement Property Continues to Qualify After 2026

Key Takeaway

The IRS provides favorable guidance allowing normal replacement and modernization expenditures after 2026.  However, a new structure or new business operation started after 2026 may not be eligible as QOZBP – thereby jeopardizing the 70/30 QOZB testing.

Qualifying Replacement Activities

Examples include:

• Replacement windows.
• Appliances.
• Flooring.
• Fixtures.
• Equipment modernization.
• Technology upgrades.
• Restaurant equipment replacements.

Limitation

The relief does not apply to:

• Business expansions.
• New facilities.
• New product lines.
• New business ventures.

Practical Effect

Existing OZ businesses may generally continue normal operations, maintenance, and modernization activities without jeopardizing OZ status.

9. Existing OZ Census Tracts Expire, But QOFs and QOZBs Receive Long-Term Safe Harbors

Key Takeaway

The IRS recognizes that many QOF investments will remain outstanding long after the original OZ designations expire.

Existing Expiration Dates

Current OZ designations expire:

• December 31, 2027, for Puerto Rico tracts.
• December 31, 2028, for all other original OZ tracts.

IRS Safe Harbor

The Notice provides that QOFs and QOZBs may continue treating expired OZ tracts as qualified zones through December 31, 2047, for purposes of:

• QOZ business property requirements.
• 50% gross income tests.
• Intangible property tests.
• Other key QOZB compliance requirements.

Why This Matters

Without this relief, many existing OZ projects could have faced substantial uncertainty once the original designation periods ended.

10. New OZ Designations Beginning January 1, 2027

Key Takeaway

The Notice reconfirms how the new OZ designation cycle will work.

IRS Guidance

• States will nominate a new round of OZs in 2026.
• Newly designated tracts will become effective January 1, 2027.
• The new designation period generally runs:
• January 1, 2027, through December 31, 2036.

Additional Clarification

The number of zones designated during the original OZ program does not reduce the number of zones that may be designated in the new cycle.  We anticipate that the number of eligible OZ 2.0 census tract may decrease by approximately 25% compared with the current 8,764 census tracts, under OZ 1.0.

Notice 2026-40 provides important clarity as taxpayers, fund managers, and developers prepare for the transition from OZ 1.0 to OZ 2.0. While several taxpayer-favorable provisions remain available, the guidance also introduces new limitations that may require action before December 31, 2026. Investors and sponsors should evaluate existing structures, working capital safe harbor plans, and anticipated gain events well in advance of the transition period to maximize available Opportunity Zone benefits.

For additional information and planning ideas, please contact the HCVT OZ Team at: OZTeam@hcvt.com

Source: IRS Notice 2026-40, Transitional Guidance on Qualified Opportunity Zones under IRC §§1400Z-1 and 1400Z-2.

Thank you for the assistance of Ashley Tison of OZ Pros and Gerry Reihsen of Reihsen & Associates.