Transition Guidelines for New Qualified Opportunity Zones

At a Glance

• If an investment in an originally designated QOZ resulted in an "inclusion event" gain, investors will have the opportunity to reinvest that gain (within 180 days) into a different qualified investment.
• Property acquired after December 31, 2026, must be within the newly designated QOZs to be treated as qualified opportunity zone business property, subject to limited exceptions.
• Transitional relief allows a qualified opportunity zone business (QOZB) to continue to meet the requirements regarding its use of tangible property, conduct of an active trade or business, and use of intangibles as occurring in a QOZ despite the expiration of the QOZ’s designation.

Background

The Internal Revenue Service recently released Notice 2026-40, providing transitional guidance on how qualified opportunity zone (QOZ) incentives made permanent through the One Big Beautiful Bill Act (OBBBA) will affect pre-existing QOZ designations made under the Tax Cut and Jobs Act (TCJA) and pre-existing investments made under the original TCJA regime. The QOZ rules originally required recognition of gains by December 31, 2026, and the initial QOZ designations expire on December 31, 2028. New designations will be in effect starting January 1, 2027, and will end on December 31, 2036, with new zones being designated every 10 years.¹

Notice 2026-40 provides guidance on four transition issues: (1) overlap between original and new QOZ designations, (2) eligibility of inclusion event gains for deferral, (3) investing in QOZs after a designation expires, and (4) meeting certain QOZ requirements after a designation expires.

1. Designation of Opportunity Zones

   The overlap between originally designated zones and the new designation period will not limit the amount of opportunity zones that states can designate in the new designation period. The QOZs designated under TCJA will not expire until 2027 or 2028. State governments will designate the new QOZs under OBBBA, and these new designations will be available for investment by January 1, 2027.² For the new designations, a state government is limited to 25% of the total number of low-income community population census tracts in the state. The notice clarifies that previously designated zones are not factored into the limit.

2. Reinvesting Inclusion Event Gains

   If an investment in an originally designated QOZ resulted in an "inclusion event" gain, investors will have the opportunity to reinvest that gain (within 180 days) into a different qualified investment. Reinvesting the gain into a qualified opportunity fund (QOF) would allow a new period of deferral (allowing investors to defer their gain for up to five years from the restart date) and restart the clock for the 10-year holding period required for the exclusion of gain on an ultimate disposition of the investment.

   Note that a reinvestment prolongs deferral and may offer a basis step-up that was not available under the TCJA, but the 10-year holding period for gain exclusion and the five-year holding period for basis step-up both reset if inclusion event gains are reinvested.

3. Guidance on Tangible Property

   Property acquired after December 31, 2026, must be within the newly designated QOZs to be treated as qualified opportunity zone business property (QOZBP), subject to two exceptions:

   a) Exception for a working capital safe harbor (WCSH) plan

   This safe harbor for working capital assets is available only if: by December 31, 2026, the qualified opportunity zone business (QOZB): (i) adopts a written plan containing a schedule for the expenditure of the assets (consistent with the WCSH set forth in US Treasury regulations), (ii) receives at least 10% of the total estimated working capital assets in the plan, and (iii) spends at least 5% of the total estimated working capital assets in the plan.

   b) Exception for tangible property acquired in the ordinary course of business

   Property will be treated as QOZBP despite being in an expired QOZ if it is acquired in the "ordinary course of business," which includes replacing existing tangible property in the ordinary course, and modernizations necessary to continue trade or business operations. It does not include expansion of a trade or business or transition into another trade or business.

4. Compliance after QOZ Designation Expires

   QOFs and QOZBs must comply with certain important requirements. In particular, Notice 2026-40 provides guidance about the requirements that: (a) substantially all of the use of tangible property be in an opportunity zone for substantially all of the QOF's or the QOZB's holding period of such tangible property, and (b) at least 50% of a QOZB's income be derived from an active trade or business in an opportunity zone and a substantial portion of the QOZB's intangible property be used in an opportunity zone.

   a) "Substantially all" use test

   Notice 2026-40 provides that even if a QOZ designation period ends, the QOZ will continue to be treated as a QOZ through December 31, 2047, if: (i) the property would be QOZBP if not for expiration of old designation zones, and (ii) the property was acquired either before the end of the designation period or pursuant to the two exceptions identified under Section 3.

   b) Active trade or business and intangible use requirements

   Notice 2026-40 provides that, if a QOZ's designation period has ended, for purposes of the requirements that it derive 50% of its income from an active trade or business in a QOZ and that it use a substantial portion of its intangible property in a QOZ, a QOZB may continue to treat the zone as a QOZ through December 31, 2047, if the QOZB has begun to engage in the active conduct of trade or business before the QOZ period's expiration or has made use of the WCSH exception.

Stay Tuned

Notice 2026-40 is a precursor for upcoming proposed regulations on QOZs that the Department of Treasury intends to issue.

For further information, you may contact the author.

Summer associate Lucky Kancherla contributed to this update.