Proposed Opportunity Zone Extension Raises Planning Considerations

The Republican tax reform bill passed by the House on May 22 would extend the Qualified Opportunity Zone (QOZ) provisions with some important modifications and new reporting requirements. Although the bill is not yet final, investors should consider the potential implications on their current planning decisions.

The QOZ changes in the bill would modify the program in significant ways, and the industry is informally referring to the original provisions from 2017 as “QOZ 1.0,” while the new bill’s provisions have been referred to as “QOZ 2.0.” Key aspects of the QOZ 2.0 provisions include the following:

• New deadline: The deadline for making qualifying tax deferrals of eligible capital gains would be extended from December 31, 2026, to December 31, 2033. The new mandatory recognition date for investments made after 2026 would be December 31, 2033.
• Prior investments: The mandatory recognition date for investments made before the end of 2026 would remain December 31, 2026. Taxpayers had hoped for an extension of this date, and changes are still possible in the Senate.  
• Ordinary income: Taxpayers could defer up to $10,000 of ordinary income through QOF investments, which would effectively become a permanent exclusion due to the basis step up that would offset mandatory recognition.
• New reporting: Qualified Opportunity Funds (QOFs) and QOZ businesses (QOZBs) would be subject to enhanced annual disclosures and stricter compliance rules, which would be aimed at promoting transparency and measurable impact. Noncompliance would carry increased penalties.
• New zones: Current QOZ designations would expire early at the end of 2026, and governors would be tasked with designating new QOZs under updated criteria, with a new emphasis on rural low-income areas (Rural QOZ). This would be a shift from more urban-focused current law designations and is expected to reduce the number of eligible census tracts. 
• Substantial Improvement Requirement: The substantial improvement standard for Rural QOZs would drop from 100% to 50%, but remain the same for other QOZ areas.
• Basis increase: The bill would offer a permanent 10% reduction of the deferred gain for investments made after 2026 that are held for at least five years. The original program offered a similar reduction, plus an additional 5% if the investment was held seven years. Rural QOZ investments held five years would qualify for a 30% reduction.
• Permanent exclusion: Like with the current program, gains from the sale of QOFs or QOF assets held at least 10 years would continue to be fully excluded from tax.

Key Questions

The legislation raises several issues that may need to be resolved through guidance. It is not clear how the early termination of QOZs would affect existing investments, and whether there will be any “grandfathering” or transition rules for QOFs or QOZBs. In addition, the IRS will need to issue forms and guidance for complying with the new reporting requirements.

The bill does not address whether gain from existing QOZ investments, including gain arising from the mandatory recognition date on December 31, 2026, can be reinvested in a QOZ under the new rules. There is no explicit language in the current bill that would prevent this, though it is not clear how the IRS might consider these transactions.

The amended criteria for designating zones give some indication of how census tracts will be selected, but it is unclear whether the geographic areas covered by newly designated rural zones will match the economic potential of original QOZs.

Planning Considerations

The legislation is not yet final, and changes are possible as the Senate considers the bill. Nonetheless, enactment would significantly alter the investment landscape, and taxpayers should consider the potential impact on current investment decisions. The timing of capital gains transactions may be particularly important. 

Delaying a capital gain transaction could allow taxpayers to make a deferral election in 2027 and defer recognizing the gain until as late as December 31, 2033. Taxpayers generally have 180 days from the transaction triggering the gain to make an election. On the other hand, QOZ designations are likely to change in 2027. Taxpayers planning an investment in a geographic area that is unlikely to be re-designated may need to make the investment before the end of 2026. Existing QOFs and QOZBs should consider their long-term capital needs, as it is not clear whether any “grandfathering” relief will allow additional qualified investments into funds operating in QOZs that are not re-designated. 

The new reporting rules will apply to both new and existing QOZs and QOZBs for tax years beginning after the date of enactment. Taxpayers will need to collect and report substantial new information that has not previously been required, including the average number of full-time equivalent employees, the North American Industry Classification System (NAICS) code for the trade or business, the number of residential units (if any), and whether property is owned or leased.