The end of the QOF deferral period is quickly approaching. What must I know before year-end?

Investors in qualified opportunity funds (QOFs) always knew that this day would come. The deferral period for eligible gains invested into a QOF ends December 31, 2026. What may be less apparent is how much gain they will have to recognize. For a leveraged real estate investment, the answer may bear little resemblance to the value of the investor’s remaining equity. As the deadline approaches, investors should examine the inclusion calculation, the cash needed to pay the tax, and whether a transaction before year-end could permit renewed deferral under the next phase of the qualified opportunity zone (QOZ) program, commonly called QOZ 2.0.

The bill is coming due

For investments in QOFs made prior to December 31, 2026, investors enjoyed deferring the tax bill until December 31, 2026. The deferred gain is included in income on the earlier of an inclusion event or December 31, 2026. The year-end inclusion does not require the QOF to sell an asset, make a distribution, or return capital. An investor may therefore owe tax without receiving any cash from the investment.

Qualifying investments made by December 31, 2021, and held through the inclusion date generally receive a 10% basis increase resulting in a reduced gain inclusion. For investments made by December 31, 2019, and held for at least seven years thereafter, the increase in basis is 15%. These adjustments reduce the deferred gain subject to tax, but investors still need to plan for the remaining liability and any estimated tax obligations.

Economic depreciation may not be reflected in the gain recognition

The statute provides that the amount of gain to be included in gross income is equal to the lesser of the amount of eligible gain invested or the fair market value of the investment as determined on the gain recognition date (i.e., December 31, 2026, for most QOFs). For investments that have not performed as well as hoped, one might expect a reduction in the gain included in income. The reference to “fair market value” in the statute implies that a taxpayer should hire an appraiser to value the QOF interest. Following the plain reading of the statutory text, if the value of the QOF interest is less than the amount invested, the gain should be reduced.

However, Treas. Reg. § 1.1400Z2(b)-1(e)(4) provides a special rule that significantly departs from the statutory text for QOFs classified as partnerships and S corporations. For an investment held on December 31, 2026, the inclusion is the lesser of the remaining deferred gain, reduced by the applicable five- and seven-year basis increases, or the gain that would be recognized on a fully taxable sale of the investment at fair market value.

For a partnership QOF, that hypothetical sale takes account of the investor’s share of partnership liabilities in the amount realized. Debt also generally increases the investor’s outside basis, but depreciation, other allocated losses, and distributions can reduce that basis. As a result, the calculation may produce substantial gain even where the underlying real estate or business has lost value and little equity remains.

The Treasury regulation in question

The preamble to the final regulations discusses the concern of the US Department of the Treasury and the Internal Revenue Service (IRS) that investors could avoid recognition of deferred gain when the value of their interests has been reduced by debt-financed deductions or distributions. For example, a QOF could borrow against its property and distribute the proceeds. Looking only at the reduced value of the partnership interest would fail to account for the cash the investor had already received.

The rule also applies where no cash has been distributed and the investment has suffered a genuine economic loss. Treasury and the IRS expressly considered objections concerning debt-financed losses and retained the rule, stating that it conformed to the underlying intent of the deferral provision. A potential challenge would therefore need to address that explanation as well as the statute’s express reference to fair market value. The statute gave Treasury authority to issue regulations to avoid abusive transactions. This raises the question of whether depreciation deductions taken in the ordinary course should be viewed as abusive.

In Notice 2026-55, the IRS now asks whether the inclusion rules should be clarified for debt-financed distributions and losses. The notice does not change the existing calculation or provide relief from the 2026 inclusion, but it shows that the IRS is considering whether the regulation oversteps. Comments are due November 23, 2026, and investors and sponsors with significant exposure may want to weigh in.

In Loper Bright Enterprises v. Raimondo, the US Supreme Court held that courts must exercise independent judgment in interpreting statutes rather than defer to an agency merely because the statute is ambiguous. That decision does not itself invalidate the QOF regulation, which was issued under the express grant of authority in Section 1400Z-2(e)(4), including its anti-abuse authority. For an investor facing a material difference between the statutory and regulatory calculations, a position contrary to the regulation would require careful analysis of the legal support, disclosure requirements, and potential controversy.

How to roll gain into QOZ 2.0

On January 1, 2027, QOZ 2.0 comes into effect. Many taxpayers have asked whether the gain that is included in income on December 31, 2026, from a QOZ 1.0 investment could be reinvested into a QOZ 2.0 investment, thereby further deferring the tax bill. Notice 2026-40 answers that question. Notice 2026-40 distinguishes the automatic December 31 inclusion from gain arising prior to December 31 by the triggering of an inclusion event. Under the notice, the automatic inclusion cannot be deferred again. The investor, of course, remains eligible for the 10-year exclusion on the existing investment. The 10-year benefit is the most important tax benefit of the QOF program. Paying the tax liability on the automatic December 31 inclusion does not terminate that benefit.

By contrast, otherwise eligible gain arising from an inclusion event occurring prior to December 31, 2026, such as a gift of the QOF interest, may be deferred through a new qualifying investment within 180 days of the event. A transaction during the remaining months of 2026 would leave an investment period extending into 2027. The regulations set forth numerous ways that an inclusion event may occur prior to December 31, 2026.

A qualifying reinvestment made on or after January 1, 2027, would fall under QOZ 2.0. The new investment generally offers a five-year deferral and, if held for five years, a 10% basis increase, or 30% for an investment in a qualified rural opportunity fund.

That additional deferral must be weighed against the benefits being surrendered. The portion of the original investment subject to the inclusion event ceases to qualify for the 10-year exclusion, and the replacement investment begins a new 10-year holding period. For an investor who entered the original QOF in 2019 or 2020, the existing holding period may be valuable. The appropriate course depends on the expected appreciation, available liquidity, and economics of the proposed transaction. For QOZ 1.0 investments that are not expected to pan out, this may be an appropriate path forward.

Notice 2026-55 also asks whether renewed deferral should be limited to inclusion events treated as sales or exchanges. The request does not change the current rules, but until further guidance is issued, an investor seeking renewed deferral should generally rely on a taxable sale of the QOF interest rather than a distribution or other type of inclusion event.

Planning before year-end

Investors should work with their tax advisors to confirm the remaining deferred gain, applicable basis adjustments, prior inclusion events, and current investment value. For partnership investments, the review also needs to reconcile outside basis and the investor’s share of liabilities, including amounts attributable to lower-tier partnerships. Those records are necessary to determine whether a decline in value actually reduces the inclusion under the regulations.

The projected gain should then be considered alongside available capital losses and other tax attributes. The included gain generally retains the character it had when originally deferred, which affects how it can be offset. Investors considering a transaction to obtain renewed deferral should compare that alternative with retaining the original investment and its potential 10-year benefit. That analysis, and any transaction needed to implement it, should be completed before the mandatory inclusion, not left until the 2026 return is prepared.

For questions about how the 2026 inclusion affects a particular investment, please contact either of the authors or your regular McDermott Will & Schulte lawyer.