Capital Gains Deferral Under Original OZ Program Is Ending

Time is running out for investors to explore options for how best to handle resulting tax liability.

Investors in the qualified opportunity zone (QOZ) program are facing a critical milestone this year: Any capital gains that were previously deferred into qualified opportunity fund (QOF) investments will become taxable again on Dec. 31. The question investors should be asking is whether they have minimized the amount of capital gain to be recognized on that date.

The opportunity zone (OZ) tax incentive was created in 2017 as part of the Tax Cuts and Jobs Act (TCJA). Since then, investors have been able to reinvest eligible capital gains into a QOF in exchange for three tax benefits:

1. Income tax deferral on those gains until Dec. 31, 2026 (deferral benefit).
2. Basis step-ups equal to a maximum 15% that reduce the amount of gain to be recognized as income (reduction benefit). 
3. No taxation on the appreciation of a QOF investment over and above the original investment (exclusion benefit).

As established under TCJA, the deferral period for OZ investors was always set to expire at the end of 2026, regardless of whether an investor deferred capital gains back in 2018 or as recently as 2025. The capital gain retains its tax attributes throughout the deferral period. For example, if an investor deferred long-term capital gain, they would recognize long-term capital gain at the end of this year. It will also generate a tax liability using the tax rates in effect for the 2026 tax year. The amount of capital gain an investor will recognize is the lesser of either the amount of capital gain deferred or the fair market value of the QOF interest over the tax basis in the QOF interest. The option to look at the fair market value of the QOF interest as of Dec. 31 provides investors with an important tax planning opportunity.

Pursuing the Fair Market Value Option

These past few years have presented many real estate projects with challenging market conditions that can affect the fair market value of an investment. The process of performing a business valuation considers not only the impact of these market conditions but also the nature of the investment (public or private) and whether an investor is in a position of control to consider discounts for the lack of marketability. The generally accepted practice of applying discounts in the process of performing a valuation could put an investor in a position where the fair market value option provides a lower amount of gain to be recognized. If an investment has appreciated, the investor would simply choose to recognize the amount of originally deferred gains into their taxable income.

As of mid-April, the IRS had yet to provide guidance regarding how investors will be required to report the 2026 gain recognition. OZ investors have been filing Form 8997 with their tax returns. The form “tracks” the deferred gain and gives the IRS a starting point for the income it expects to see recognized with the 2026 tax return. If an investor is going to recognize an amount that is different from the originally deferred gain, it is likely that the IRS will require support for that amount.  

In the case of a real estate-focused OZ investment, many investors may be tempted to just get an appraisal of the property and use that as evidence for the fair market value of the QOF interest. However, there is established case law where this approach has been rejected as acceptable evidence of the fair market value of the related partnership interest that owns the real estate. In addition, an appraisal report does not consider valuation discounts for the lack of marketability and lack of control. A business valuation incorporates an appraisal but also uses accepted valuation methodologies that document assumptions and sources of data and the qualifications of the valuation provider.  

For QOFs taxed as S corporations or partnerships, the regulations under the OZ statute require additional calculations to be performed beyond what is done in a typical business valuation. Therefore, combining a qualified business valuation with a qualified OZ tax adviser is essential for properly reporting the gain.  

Having a proper business valuation of the QOF interest provides a supportable defense of the gain amount being recognized in the event of IRS scrutiny (assuming it is less than the amount of original gain that was deferred).

The tax liability resulting from the gain triggered on Dec. 31 will be due April 15, 2027. This will apply regardless of whether the OZ investment is liquid. The sooner that investors can start working with their tax and investment advisers to plan for this event, the better. Not only does proactive planning allow for more time to address any liquidity concerns, but it also provides a longer runway to employ other tax minimization strategies (such as tax loss harvesting, among others) that could further reduce the related tax bill. At minimum, investors should be having a conversation with their advisers and fund managers about whether the fair market value option would make sense to pursue — before it is too late. 

Angel Rice is a partner at Cohen & Co Advisory, LLC. Dave Sobochan is a partner and market leader of the firm’s real estate and construction group.

This article is for informational purposes only and should not be construed as tax advice.

• Magazine Article
• Advocacy
• Finance
• Tax
• Capital Gains
• Opportunity Zones (OZ)