IRS Notice 2026-40 Provides Transition Guidance for the New Opportunity Zone Regime

On June 18, 2026, the Internal Revenue Service released Notice 2026-40, announcing Treasury’s intent to issue proposed regulations implementing the amendments to the Qualified Opportunity Zone (QOZ) rules enacted as part of the One, Big, Beautiful Bill Act (OBBBA). The Notice provides important interim guidance for investors, Qualified Opportunity Funds (QOFs), and Qualified Opportunity Zone Businesses (QOZBs) as the original Qualified Opportunity Zone program under the Tax Cuts and Jobs Act (“QOZ 1.0”) transitions to the revised Qualified Opportunity Zone regime under the OBBBA beginning January 1, 2027.

Key Takeaways

• If you invested gain in a QOF by December 31, 2026, you stay under the old rules. Any gain you haven’t yet recognized becomes taxable on that date and cannot be deferred again under the new program.
• If you invest gain in a QOF on or after January 1, 2027, the new rules apply: your deferral period restarts for five years, and your basis reduction shrinks to 10% (30% for rural funds).
• If an inclusion event happens, you can generally still roll that gain into a new QOF within 180 days under the new rules, though it isn’t yet clear whether anti-abuse rules could block a second rollover.
• Property you buy for an existing zone after 2026 generally will not qualify as Opportunity Zone property unless it fits a transition exception, such as a pre-2027 working capital plan or a routine replacement or upgrade of existing property.
• Funds and businesses may be able to keep treating an expired zone as a QOZ for limited purposes if the property or operations were already in place before the zone’s designation expired.
• New zone designations starting in 2027 do not reduce the number of low-income neighborhoods a state can designate; zones designated in 2026 under the new rules run from January 1, 2027 through December 31, 2036.

Background

The QOZ 1.0 regime permitted taxpayers to defer eligible capital gains invested in a QOF until the earlier of an inclusion event or December 31, 2026. Under QOZ 1.0, taxpayers also could receive basis step-ups of up to 15% of the deferred gain and, if the investment was held for at least 10 years, elect to step the basis of the investment up to its fair market value upon disposition. The fair market value (“FMV”) election generally remains available through December 31, 2047.

The OBBBA substantially revised the QOZ 1.0 regime and created a new, permanent framework beginning January 1, 2027 (“QOZ 2.0”). Rather than relying on the fixed December 31, 2026 gain recognition date that applied under QOZ 1.0, QOZ 2.0 adopts a rolling five-year gain deferral period. The OBBBA also modifies the basis adjustment rules by providing a single 10% basis step-up after five years (30% for Qualified Rural Opportunity Funds), revises the 10-year FMV election by permitting taxpayers to make the election upon a disposition or on the 30th anniversary of the investment, tightens the requirements for census tract eligibility, and introduces a new 10-year QOZ designation cycle.

Summary of Notice 2026-40

Although the OBBBA significantly revised the Opportunity Zone rules, it did not include detailed transition provisions addressing the interaction between the expiring QOZ 1.0 regime and the new QOZ 2.0 framework. IRS Notice 2026-40 fills many of these gaps and provides interim guidance pending the issuance of proposed regulations. The Notice generally confirms that Treasury intends to issue regulations incorporating rules substantially similar to those described in the Notice.

Section 1400Z-1 Designation Rules:

The Notice clarifies that the 25% limitation on the designation of low-income communities (“LICs”) is applied independently for each designation cycle. As a result, previously-designated QOZs do not reduce the number of census tracts that a state may nominate for designation beginning in 2027. For census tracts designated during 2026 under the new regime, the designation period begins on January 1, 2027 and remains effective through December 31, 2036.

Guidance for Investors

• If you invest by December 31, 2026: You stay under the old rules. Any gain you have not yet recognized becomes taxable on December 31, 2026, and you cannot defer it again by reinvesting under the new program. You still hold a qualifying investment, though, and can generally still make the 10-year fair market value election if you meet the other requirements.
• If you invest on or after January 1, 2027: It does not matter when you realized the gain — if you invest it in a QOF on or after January 1, 2027, the new rules apply. You can defer tax until the earliest of a cash-out event, a sale, or five years after you invest, and you get a 10% basis reduction after five years (30% for rural funds).
• Inclusion event gain: You can generally still roll that gain into a new QOF under the new rules, as long as you reinvest within 180 days and meet the other requirements. But the portion of your original investment that triggered the inclusion event stops counting as a qualifying investment. The Notice confirms this rollover is available, though it does not say whether anti-abuse rules could block a second rollover down the road.

QOF/QOZB Transitional Guidance

Property you buy after December 31, 2026 generally will not count as qualifying Opportunity Zone property unless it is located in a zone designated under the new program. Zones designated only under the old program do not automatically carry over, so property bought after 2026 in those older zones generally will not qualify unless one of the transition exceptions below applies.

The Notice offers two exceptions for property in previously designated zones:

• Working Capital Safe Harbor transition rule: Property can still qualify if you are buying it under a written working capital plan adopted by December 31, 2026, and you are generally following that plan. You also need to show that at least 10% of the planned working capital came in, and at least 5% was spent, by the end of 2026 (amounts you are locked into spending under a pre-2027 contract count as spent). Fund sponsors with projects in existing zones should check whether their working capital plans and spending timelines meet these requirements.

• Ordinary-course replacement or modernization rule: Property bought after 2026 can also qualify if it is a routine replacement or upgrade of existing property in your zone — think replacing windows or appliances in an apartment building, or modernizing restaurant equipment. This exception does not cover new construction or expanding into a new line of business.

Compliance Testing After a Designation Period Ends

The Notice also explains what happens once a zone’s designation expires. The IRS expects upcoming regulations to let funds and businesses keep treating an expired zone as a QOZ through December 31, 2047, but only for limited purposes. For the requirement that business property be substantially used in the zone, that continued treatment applies if the property was acquired before the designation expired or under one of the exceptions above. For the tests requiring that most of a business’s income and intangible property use come from the zone, continued treatment applies if the business was already operating there before the designation expired, or reasonably expected to, under a qualifying written plan.

If you would like to learn more about the new legislation and its impact on QOFs please feel to contact Louis Schatz or Elva Saltzman.This blog will be updated when more information becomes available.