Following The Yellow Brick Road Beyond 2026: IRS Notice 2026-40 (Transitional Guidance On The Opportunity Zone Program)

For the past year since the passage of the One Big Beautiful Bill Act of 2025 (“OBBBA”), which permanently extended the qualified opportunity zone program (the “OZ Program”), many investors, advisors and other stakeholders in the OZ community have been anxiously mapping out scenarios around the transition from “OZ 1.0” (the original program enacted under the Tax Cuts and Jobs Act of 2017) to “OZ 2.0” (the permanently extended program under the OBBBA).¹ Last month, the IRS released some preliminary guidance around this transition with the release of IRS Notice 2026-40 (the “Notice”).

While most of the guidance in the Notice is welcome news and provides some clarity around key issues, there are a few critical takeaways which can impact developments in progress, or those that have yet to begin, in qualified opportunity zones designated under OZ 1.0.

QOZ designations: Application of 25% limitation

As part of OZ 2.0, each state is able to nominate a new round of qualified opportunity zones (“QOZs”) for each 10-year designation period. However, there is technically a 2-year overlap between the OZ 1.0 QOZs and the OZ 2.0 QOZs, and the relevant statutory language around QOZ designations includes language that limits the number of QOZs in each state “during any period” to no more than 25% of the number of low-income communities in each state. As a result, there was a concern that a state could not have OZ 1.0 QOZs and OZ 2.0 QOZs without violating that provision.

The Notice clarified that “during any period” means each QOZ designation period, and therefore QOZs designated under OZ 1.0 will not reduce the number of population census tracts a state may newly designate as QOZs under OZ 2.0. The first OZ 2.0 designation period begins January 1, 2027, and ends December 31, 2036.

Inclusion events and investor deferral elections of eligible gain

Under the OZ Program, there have always been two types of inclusion events for investors. Under OZ 1.0, an investor that invested eligible gains into a qualified opportunity fund (“QOF”) would recognize that deferred gain on the earlier of (i) a sale, exchange or other disposition of the QOF interest, or other specified inclusion event as further described in applicable Treasury Regulations (this type of inclusion event, an “Early Inclusion Event”), or (ii) December 31, 2026 (the “Deemed Inclusion Event”).

Under OZ 2.0, the framework is the same, except that the Deemed Inclusion Event works on a rolling investor-by-investor and investment-by-investment basis, so each QOF investor’s Deemed Inclusion Event is 5 years after the investor’s investment of eligible gain into the QOF.

Critically, under the Treasury Regulations, any deferred gain that is recognized as a result of an Early Inclusion Event is treated as a new eligible gain that can be invested into a QOF during the 180-day period beginning on the date of the Early Inclusion Event.

The Notice clarified that (i) deferred gain that is recognized as a result of a Deemed Inclusion Event does not result in new eligible gain, (ii) deferred gain that is recognized as a result of an Early Inclusion Event can be invested in a QOF for OZ 2.0 benefits as long as (x) the 180-day reinvestment period ends on or after January 1, 2027, and (y) the eligible gain is invested in a QOF on or after January 1, 2027 (in which case the holding period for electing the OZ 2.0 benefits of the 10-year rule begins on the date of the investment), and (iii) investors that recognize deferred gain as a result of a Deemed Inclusion Event remain eligible to elect the OZ 1.0 benefits of the 10-year rule, provided they continue to hold their QOF investment and other applicable requirements are met.

Tangible property in QOZs

The location of tangible property is critical for an OZ investment, so OZ stakeholders were eagerly awaiting guidance on how to navigate the transition from the OZ 1.0 QOZs to the OZ 2.0 QOZs. Even though the OZ 1.0 QOZs do not expire until the end of 2028, one of the changes to the OZ Program rules under the OBBBA limits acquisitions of tangible property in an OZ 1.0 QOZ after 2026. The Notice brings this new rule to the forefront and provides a few avenues for post-2026 acquisitions of tangible property in an OZ 1.0 QOZ by QOFs and qualified opportunity zone businesses (“QOZBs”).

Under the Notice, all tangible property acquired after 2026 by a QOF or a QOZB must either (i) be acquired for use in an OZ 2.0 QOZ, or (ii) meet one of two exceptions. Note that the two exceptions described below are not limited solely to the transitional period of 2027 and 2028.

The WCSH Exception

The first exception is for tangible property that is covered by a qualifying working capital safe harbor plan (a “WCSH”). As a reminder, WCSHs must designate in writing the use of a QOZB’s working capital assets for the development of a trade or business in a QOZ (including as appropriate the acquisition, construction and/or substantial improvement of tangible property in a QOZ), and WCSHs must include a written schedule for the expenditure of those assets within 31 months. Lastly, the QOZB must use its working capital assets in a manner that is substantially consistent with the written designation and written schedule.

Under the WCSH Exception, tangible property in an OZ 1.0 QOZ may be acquired after 2026 if all four conditions are met:

1. The WCSH was adopted on or before December 31, 2026;
2. Acquisitions of tangible property in an OZ 1.0 QOZ are made in a manner substantially consistent with that plan;
3. The QOZB received at least 10% of total estimated working capital assets by December 31, 2026; and
4. The QOZB expended at least 5% of total estimated working capital assets by December 31, 2026.

The Notice contains several examples to illustrate the application of the WCSH Exception.

Under the second exception, tangible property in an OZ 1.0 QOZ may be acquired after 2026 in the ordinary course of a QOF or QOZB’s trade or business to replace existing tangible business property. Replacements in the ordinary course of a trade or business include replacement or modernization of property necessary to continue business operations, but replacements do not include tangible property that is acquired to expand a trade or business or to transition into a new trade or business.

The Notice contains several helpful examples to illustrate the Ordinary Course of Business Exception (e.g. replacement of windows and new appliance purchase in an apartment building are qualifying replacements). However, questions remain about the scope of this exception. For example, what happens if a qualified property is destroyed through a fire or other casualty?

The exclusion of tangible property for expansions will likely be limiting for certain QOZBs that otherwise cannot document intended acquisitions under the WCSH Exception by the end of the year.

QOZB compliance tests

Most of the requirements under the OZ Program require continued nexus to a QOZ, so QOFs and QOZBs were going to need guidance around the expiration of the OZ 1.0 QOZs after 2028 even if the OBBBA had never permanently extended the OZ Program.

The Notice provided these welcome commonsense safe harbors, which are expected to be included in the upcoming proposed regulations.

• For tangible property to qualify as qualified opportunity zone business property (“QOZBP”), substantially all of the use of that property must be in a QOZ for substantially all of the QOF or QOZB’s holding period for such property. Under the Notice, if property in an OZ 1.0 QOZ otherwise qualifies as QOZBP, a QOF or QOZB that acquires that property before expiration of the OZ 1.0 QOZs, or pursuant to the WCSH Exception or the Ordinary Course of Business Exception, may continue to treat the OZ 1.0 QOZ as a QOZ for purposes of this QOZBP “substantial use” test even after the OZ 1.0 QOZs expire.
• For an entity to qualify as a QOZB, at least 50 percent of its gross income must be derived from the active conduct of a trade or business in a QOZ, and a substantial portion of its intangible property must be used in the active conduct of a trade or business in a QOZ. Under the Notice, a QOZB that has begun to engage in the active conduct of a trade or business within an OZ 1.0 QOZ before expiration of the OZ 1.0 QOZs, or that reasonably anticipates beginning to do so in accordance with the WCSH Exception, may continue to treat the OZ 1.0 QOZ as a QOZ for purposes of the gross income and intangible property tests even after the OZ 1.0 QOZs expire.

Next steps

The Notice announced that the IRS and Treasury Department intend to issue proposed regulations with rules similar to those described in the Notice, and that the forthcoming proposed regulations will propose that any final regulations apply to taxable years ending after the date of the Notice.