The Notice provides an exception to the rule for qualified opportunity zone business property, allowing the replacement/repair of property as part of the ordinary course of business.

Treasury and the IRS announced in Notice 2026-40 (Notice) the intent to issue proposed regulations with transitional guidance addressing Opportunity Zone designations and investments before and after December 31, 2026, when changes under the One Big Beautiful Bill Act (OBBBA) become effective.

The forthcoming proposed regulations are expected to state that the final regulations will apply to tax years ending after Notice 2026-40 was issued.

Background

IRC Sections 1400Z-1 and 1400Z-2 established the Opportunity Zone regime, which allows taxpayers to defer tax on eligible gains by investing in a qualified opportunity fund (QOF) (a specially created investment vehicle that invests at least 90% of its assets in Opportunity Zone Property). Qualified Opportunity Zones (QOZs) were designated in 2018 and will remain in place through December 31, 2028 (December 31, 2027, if in Puerto Rico). If statutory requirements are satisfied, taxpayers may also reduce or exclude certain gains associated with those investments. Under the original regime (OZ 1.0), investors could:

• Invest in a designated QOF and defer tax on capital gains until no later than December 31, 2026
• Receive a 10% or 15% reduction on their deferred capital gains tax bill by increasing the basis of the original deferred gain if they held the QOF investment for five or seven years, respectively, as of December 31, 2026
• Receive the added benefit of paying no tax on any realized appreciation in the QOF investment If they held the QOF investment for at least 10 years

The OBBBA modified these provisions by:

• Making the Opportunity Zone regime permanent
• Creating rolling, 10-year QOZ designations beginning in 2027 (OZ 2.0)
• Changing the definition of QOZBP, effectively ending the 1.0 zones once the 2.0 zones come into effect, subject to the relief provided in the Notice
• Replacing the 10% and 15% reductions in deferred capital gains tax with a 10% basis step-up, after five years, in the capital gains deferred (investments in qualified rural opportunity funds receive a 30% step-up)
• Revising the 25% limitation on census tracts (which limits the number of designated QOZs to 25% of the total number of low-income community population census tracts in the state) so that it applies separately to each 10-year QOZ designation period
• Eliminating Puerto Rico's exemption from the 25% limitation.

After the OBBBA (see Tax Alert 2025-1418), the IRS clarified the new requirements on rural areas (Tax Alert 2025-2020) and census tracts (Tax Alert 2026-0851).

Notice 2026-40

25% limitation

The Notice clarifies that the 25% limitation applies to each new designation period. Therefore, the number of previously designated QOZs in a state will not affect the number of population census tracts that may be designated as QOZs beginning January 1, 2027.

Investments made on or before December 31, 2026

Taxpayers that timely invest eligible gain in a QOF on or before December 31, 2026, must include the deferred gain in income in the tax year that includes the earlier of an inclusion event (an event that requires the gain to be recognized) or December 31, 2026.

Taxpayers holding qualifying investments through that date must recognize any remaining deferred gain (known as deemed included gain), which is not eligible for further deferral.

The Notice clarifies, however, that taxpayers may continue to hold their investments and potentially qualify for the basis step-up election under IRC Section 1400Z-2(c) after December 31, 2026, if they satisfy the 10-year holding period requirement and the other requirements.

Investments made on or after January 1, 2027

The Notice explains the new framework for investments made after 2026:

• Tax may still be deferred if the gain is invested in a QOF within 180 days of the inclusion event date and other requirements are satisfied, but the portion of the investment triggering the inclusion event is no longer a qualifying investment and cannot benefit from the 10-year exclusion election.
• Deferred gain is generally included at the earliest of (1) sale or exchange, (2) an inclusion event or (3) five years after investment.
• A basis increase of 10% is available after a five-year holding period (or 30% for qualified rural opportunity funds).

Transitional guidance for QOZ businesses

For property acquired after 2026, the general rule requires the QOZBP to be acquired after the "applicable start date" of a newly designated QOZ. As a result, property acquired for use in previously designated zones generally will not qualify as QOZBP unless it was acquired for use in a QOZ that is designated after July 4, 2025 (the date of enactment of the OBBBA), or an exception applies.

For property acquired under a written working capital safe harbor plan, an exception applies if:

• The safe harbor plan is written and adopted before December 31, 2026
• The relevant property acquisitions are substantially consistent with that plan
• The QOZB receives at least 10% of the total estimated working capital assets and expends at least 5% of those assets by December 31, 2026

For property acquired in the ordinary course of business, an exception applies if the acquired property replaces existing property and is not an expansion of the business.

Implications

There are two big takeaways from the Notice. First, gains that were deferred under an Opportunity Zone program and are set to be recognized on December 31, 2026, are not eligible for reinvestment. This was widely expected although some industry participants were hopeful for a more generous interpretation.

The second takeaway concerns the transition from OZ 1.0 to OZ 2.0. While the 1.0 zones will remain in place until 2028, the Notice limits the overlap period by requiring a working capital safe harbor plan and a level of expenditure before the end of 2026. This prevents QOF investments made in 2027 from investing in the OZ 1.0 zones unless they satisfy the exception, although the threshold for what is required for taxpayers to rely on OZ 2.0 benefits while investing in a 1.0 zone is relatively low.

A lesser but nonetheless important takeaway is that a QOZ will not become ineligible if existing property is replaced as long as it is in the ordinary course of business and does not constitute an expansion. This guidance aligns with what industry participants expected.