Notice 2026-40, Internal Revenue Service (June 2026).

For practitioners advising clients on Qualified Opportunity Zone (QOZ) investments under the Internal Revenue Code (the Code), the regulatory landscape has recently undergone a major transformation. Sections 1400Z-1 and 1400Z-2, originally enacted under the Tax Cuts and Jobs Act (TCJA) of 2017 and subsequently amended by the Bipartisan Budget Act of 2018 (BBA 2018), have been substantially modified by Section 70421 of Public Law 119-21, 139 Stat. 72 (July 4, 2025), commonly referred to as the "One, Big, Beautiful Bill Act" (OBBBA).

To address critical timing mismatches and transition issues resulting from these amendments, the Department of the Treasury (Treasury Department) and the Internal Revenue Service (IRS) issued Notice 2026-40. This Notice serves as transitional administrative guidance ahead of forthcoming proposed regulations, outlining how both investors and Qualified Opportunity Funds (QOFs) must adjust their compliance and tax planning strategies.

Because this guidance is administrative rather than judicial, there is no presiding judge or court case associated with its release. However, to maintain the rigorous, technical standards of our profession, this article details the facts, statutory mechanics, and administrative determinations set forth in Notice 2026-40, making extensive use of direct quotations from the text of the Notice to illustrate the IRS's formal positions.

Statutory Background of the Opportunity Zone Framework

Prior to the enactment of the OBBBA, the Qualified Opportunity Zone regime operated under a dual-statute mechanism:

Section 1400Z-1 governed the designation of population census tracts as low-income communities (LICs) eligible for QOZ status.
Section 1400Z-2 provided taxpayers with a mechanism to defer gross income on realized gains by making a timely qualifying investment in a certified QOF.

Under the prior statutory scheme, a QOF was required to hold at least 90 percent of its assets in Qualified Opportunity Zone Property (QOZP), which is defined as qualified opportunity zone stock (QOZ stock), a qualified opportunity zone partnership interest (QOZ partnership interest), or qualified opportunity zone business property (QOZBP) under Section 1400Z-2(d)(2)(A). For property acquired on or before December 31, 2026, QOZBP required that the tangible property be used in a trade or business, acquired by "purchase" after December 31, 2017, and have its original use commence in the QOZ or be substantially improved by the QOF.

The OBBBA modified these rules for investments made and property acquired after December 31, 2026. Crucially, the OBBBA struck the historical statutory reference date of "December 31, 2017" and replaced it with the "applicable start date". Under the amended Section 1400Z-1(e)(2), the "applicable start date" is defined as "the January 1 following the date on which such QOZ was certified and designated". This statutory modification applies only to tracts designated after the enactment of the OBBBA on July 4, 2025.

Statement of Facts and Purpose of the Notice

Under the TCJA and BBA 2018 framework, previously designated QOZs were subject to a rigid 10-year designation period. Under prior Section 1400Z-1(f), the designation period for previously designated tracts ends on December 31, 2027, for QOZs deemed certified and designated in Puerto Rico (which were deemed designated as of December 22, 2017, under Section 1400Z-1(b)(3)), and on December 31, 2028, for all other previously designated QOZs.

As these historical designations near their expiration dates, taxpayers and QOFs face two major problems:

First, because previously designated zones do not have an "applicable start date" under the post-OBBBA statutory definitions (since they were certified prior to July 4, 2025), any property acquired in those zones after December 31, 2026, would fail to qualify as QOZBP under the general statutory text.
Second, because the designation of these zones will expire in 2027 and 2028, QOFs and Qualified Opportunity Zone Businesses (QOZBs) would technically fail the "substantial use" and operational compliance tests (such as the 50 percent active gross income test) that require assets and operations to be located in an active QOZ.

To prevent a sudden collapse of investment in existing zones, the IRS issued Notice 2026-40. The IRS announced that:

"the Department of the Treasury (Treasury Department) and the Internal Revenue Service (IRS) intend to issue proposed regulations regarding qualified opportunity zones (QOZs) under §§ 1400Z-1 and 1400Z-2 of the Internal Revenue Code (Code), as amended by § 70421 of Public Law 119-21, 139 Stat. 72 (July 4, 2025), commonly known as the One, Big, Beautiful Bill Act (OBBBA), including transitional guidance related to qualifying investments under §§ 1400Z-1 and 1400Z-2, as in effect prior to amendment by § 70421 of the OBBBA".

The forthcoming proposed regulations are anticipated to mirror the rules provided in Sections 3 through 5 of the Notice.

Transitional Guidance Regarding Section 1400Z-1 and the 25-Percent State Limitation

Section 1400Z-1(b)(1) permits the Chief Executive Officer (CEO) of each State, territory, or the District of Columbia to nominate LIC tracts for QOZ designation. Under prior Section 1400Z-1(d)(1), the total number of designated zones was restricted to 25 percent of the total number of LIC census tracts in the State (the "25-percent limitation").

Section 70421(a) of the OBBBA amended Section 1400Z-1 to apply this 25-percent limitation "during any period". In Notice 2026-40, Section 3.01(1), the IRS analyzed the phrase "during any period" and determined that it refers to:

"the QOZ designation period under § 1400Z- 1(e)(1) beginning on the applicable start date and ending on the day before the date that is 10 years after the applicable start date during which an LIC is designated as a QOZ".

Consequently, the IRS ruled that:

"the number of previously designated QOZs in a State will not affect the number of population census tracts that a State CEO may nominate to be designated as QOZs for the QOZ designation period beginning January 1, 2027".

This determination allows State CEOs to nominate a full new complement of census tracts for designation effective January 1, 2027, under Revenue Procedure 2026-14, without being restricted by the volume of zones designated during the TCJA era. For every community certified and designated during 2026, the new QOZ designation period begins on January 1, 2027, and ends on December 31, 2036.

Impact on Investors: Qualifying Investments and the Deemed Inclusion Date of December 31, 2026

Under the prior statutory scheme of Section 1400Z-2(b)(1)(B), taxpayers who deferred eligible gains by making an investment in a QOF on or before December 31, 2026, were required to include the deferred gain in gross income in the taxable year that included the earlier of an inclusion event or December 31, 2026. Notice 2026-40 provides critical instructions on the tax treatment of this "deemed included gain" on December 31, 2026.

First, the IRS clarified that taxpayers holding qualifying investments through December 31, 2026:

"are required to include in income in the taxable year that includes that date the amount of remaining deferred gain from the qualifying investment as calculated under prior § 1400Z-2(b)(2) and § 1.1400Z2(b)-1(e)(3) (deemed included gain)".

Second, the IRS ruled that because the taxpayer continues to hold the qualifying investment, the underlying Section 1400Z-2(a) deferral election remains in effect. Consequently, the IRS held that:

"Amounts of deemed included gain may not be deferred pursuant to either prior or current § 1400Z-2(a)(1)(A) because, as noted above, an election continues to be in effect under prior and current § 1400Z-2(a)(2) with respect to the eligible gain that gave rise to the deemed included gain on December 31, 2026. Thus, no amount of deemed included gain can be eligible gain with respect to which an election under either prior or current § 1400Z-2(a) may be made".

Importantly, however, the IRS confirmed that the recognition of this deemed included gain does not terminate the investment’s eligibility for the permanent basis step-up to fair market value upon disposition under Section 1400Z-2(c). Notice 2026-40, Section 4.01(3), explicitly states that:

"the taxpayer remains potentially eligible to make an election under § 1400Z-2(c) on the later sale or exchange of that qualifying investment".

To qualify for this election, the taxpayer must satisfy the 10-year holding period requirement and other regulatory conditions through the date of disposition.

For gains realized on or before December 31, 2026, but invested on or after January 1, 2027, the OBBBA provides a more favorable path. Under the amendments, a deferral election can be made after December 31, 2026, and the mandatory inclusion date is shifted from December 31, 2026, to the date that is five years after the investment is made. Additionally, Section 1400Z-2(b)(2)(B) permits a 10 percent basis step-up (or 30 percent in the case of a "qualified rural opportunity fund" as defined in Section 1400Z-2(b)(2)(C)) for investments held for at least five years. Taxpayers with eligible gain realized on, before, or after December 31, 2026, who timely invest on or after January 1, 2027, can defer gain recognition until the earliest of a sale/exchange, an inclusion event, or five years from the investment date.

Deferral of Inclusion Event Gains and Section 1400Z-2(c) Limitations

Notice 2026-40, Section 4.03, addresses the interaction between "inclusion event gains" and subsequent deferrals. Under Section 1.1400Z2(a)-1(b)(11)(iv)(A), gain forced into recognition due to an inclusion event may be eligible for a subsequent deferral under Section 1400Z-2(a)(1) if reinvested in a QOF within 180 days.

The IRS analyzed this transaction and ruled that for eligibility purposes, the inclusion event gain is treated as realized on the date of the inclusion event itself. However, the IRS imposed a strict limitation on the subsequent tax benefits of this reinvested portion, declaring:

"To the extent a taxpayer has an inclusion event with respect to any portion of a qualifying investment, that portion is no longer a qualifying investment and the taxpayer is not eligible to make an election pursuant to § 1400Z-2(c) with respect to that portion of the qualifying investment".

Practitioners must carefully track which portions of a client's QOF holdings have triggered inclusion events, as those specific portions are permanently barred from the 10-year fair market value basis step-up.

Transitional Property Rules: Tangible Property Acquired After December 31, 2026

Under Section 70421(c)(4)(A) of the OBBBA, the statutory language for QOZBP was amended to require that tangible property be acquired by purchase after the "applicable start date" rather than "December 31, 2017". In Notice 2026-40, Section 5.01(1), the IRS applied this rule to previously designated zones and arrived at a harsh legal conclusion:

"A previously designated QOZ does not have an 'applicable start date' under § 1400Z-1(e)(2) because its designation took place before the date of enactment of OBBBA. Therefore, property acquired by a QOF or QOZB after December 31, 2026, cannot be QOZBP unless (i) the property is acquired for use in a QOZ that is designated after July 4, 2025, or (ii) one of the exceptions in section 5.01(2) and (3) of this notice applies".

To prevent a freeze on ongoing investments and business maintenance within older zones, the IRS established two highly critical transitional safe harbor exceptions.

The Working Capital Safe Harbor Exception

Under Section 1397C(b)(8) and Section 1.1400Z2(d)-1(d)(3)(v), QOZBs may hold reasonable amounts of working capital in cash or short-term debt if designated in writing for zone development under a 31-month written expenditure schedule.

Notice 2026-40, Section 5.01(2)(b), provides that property acquired after December 31, 2026, in a previously designated QOZ pursuant to a written working capital plan will satisfy the "acquired by purchase" requirement of Section 1400Z-2(d)(2)(D)(i)(I) if and only if:

The working capital plan was adopted on or before December 31, 2026.
The relevant property acquisitions are made in a manner substantially consistent with that plan.
The QOZB received at least ten percent of the total estimated working capital assets designated in the plan by December 31, 2026.
The QOZB expended at least five percent of the total estimated working capital assets by December 31, 2026. (Importantly, Section 5.01(2)(b) permits "amounts required to be expended by a QOZB pursuant to a binding agreement entered into prior to January 1, 2027" to count as expended).

Under Section 5.01(2)(c), any stock or partnership interests acquired after December 31, 2026, pursuant to such a plan will be treated as acquired after the "applicable date". This allows QOFs to inject capital into QOZBs post-2026 to complete pre-existing developments, as illustrated by the mixed-use commercial and residential development examples in Section 5.01(4).

The Ordinary Course Replacement Exception

The second major exception allows QOFs and QOZBs to maintain their existing business operations without losing QOZBP status on replacement property. Under Section 5.01(3):

"Tangible property acquired after December 31, 2026, by a QOF or QOZB for use in the ordinary course of its trade or business in a previously designated QOZ to replace existing tangible business property may be treated as QOZBP if the requirements of § 1400Z-2(d)(2)(D) are otherwise met".

The IRS defined replacements in the ordinary course to include "the replacement or modernization of property necessary to continue the operations of the trade or business". However, the IRS strictly carved out expansion, stating that ordinary course replacements:

"do not include tangible property acquired pursuant to the expansion of a trade or business or the transition of a trade or business into a new trade or business".

This distinction is highlighted by the examples in Section 5.01(4):

Non-Qualifying Expansion (Example 1): A QOZB operating a manufacturing facility in a 2018-designated zone purchases a new warehouse on an adjacent plot in 2028 to expand capacity. Because the warehouse is an expansion and was not acquired pursuant to a pre-2027 working capital plan, it fails to qualify as QOZBP.
Qualifying Ordinary Course Replacement (Example 2): An apartment building QOZB in a 2018-designated zone replaces windows, appliances, cabinetry, and flooring during unit renovations in 2028 and 2029. These acquisitions qualify as QOZBP because they are necessary for the continued operation of the building.
Qualifying Modernization (Example 3): A restaurant QOZB in a 2018-designated zone renovates its kitchen in 2028, adding an energy-efficient ventilation system and a new point-of-sale system. Because these updates represent modernization necessary to continue operations, they qualify as QOZBP.

Post-Expiration Compliance Safe Harbors through 2047

Perhaps the most significant relief provided in Notice 2026-40 addresses the compliance crisis that QOFs and QOZBs will face once the 10-year designation periods for older zones expire on December 31, 2027 (for Puerto Rico) or December 31, 2028 (for all others).

Because the OBBBA extended the potential holding period for post-2026 investments to 30 years (with a basis step-up to fair market value under Section 1400Z-2(c) on the earlier of the sale date or the 30-year mark), and the prior regulations under Section 1.1400Z2(c)-1(c) preserved the 10-year FMV election for older investments through December 31, 2047, QOFs and QOZBs must have a mechanism to remain compliant even after their target zones are no longer designated.

Acknowledging this statutory friction, the Treasury Department and the IRS announced two critical safe harbors that will be detailed in the forthcoming proposed regulations:

Substantial Use Safe Harbor

To qualify as QOZBP, Section 1400Z-2(d)(2)(D)(i)(III) requires that "substantially all" of the use of the tangible property be in a QOZ during "substantially all" of the entity's holding period. The IRS established that a QOF or QOZB that acquired qualifying property on or before the expiration of its zone’s designation period (or post-expiration pursuant to the working capital or ordinary course replacement exceptions):

"may continue to treat a previously designated QOZ the designation of which has expired as a QOZ solely for purposes of § 1400Z-2(d)(2)(D)(i)(III) through December 31, 2047".

QOZB Compliance Tests Safe Harbor

To maintain status as a QOZB, an entity must satisfy the gross income and intangible property tests under Section 1400Z-2(d)(3)(A)(ii), which require at least 50 percent of gross income to be derived from the active conduct of a trade or business within a QOZ and a substantial portion of intangible property to be used in a QOZ. Under Section 5.02(3), the IRS ruled that:

"A QOZB that has begun to engage in the active conduct of a trade or business within a previously designated QOZ on or before the expiration of its QOZ designation period (December 31, 2027, or December 31, 2028, as applicable), or that reasonably anticipates to begin doing so in accordance with a written plan that meets the requirements of section 5.01(2) of this notice, may continue to treat a previously designated QOZ the designation of which has expired as a QOZ solely for the purposes of § 1400Z-2(d)(3)(A)(ii) through December 31, 2047".

These dual safe harbors provide an essential bridge, ensuring that investments made under the prior framework can be maintained and successfully exited via a Section 1400Z-2(c) election at any point up to the regulatory sunset on December 31, 2047.

Conclusion and Practitioner Outlook

Notice 2026-40 provides a highly structured and necessary framework to reconcile the historical TCJA rules with the OBBBA amendments. While the forced recognition of remaining deferred gains on December 31, 2026, represents a significant tax event for existing investors, the preservation of the 10-year holding period election under Section 1400Z-2(c) is a major victory. Furthermore, the safe harbors extending through December 31, 2047, allow QOFs and QOZBs to maintain compliance and preserve tax-free exit strategies long after the physical zones themselves have lost their statutory designations.

Tax professionals must immediately review their clients' QOZ portfolios to identify any potential post-2026 property acquisitions that do not meet the working capital or ordinary course replacement exceptions, and ensure that all existing QOZBs are actively engaged in business before their respective zone expiration dates.

Prepared with assistance from NotebookLM.