By: Shelby Follis, CPA, and Emily Cokeley, Ph.D., CPA
Qualified Opportunity Funds (QOFs) were first introduced by the 2017 Tax Cuts and Jobs Act, allowing taxpayers to defer capital gains by investing in low-income community tracts for an extended period as a method of promoting economic development in distressed areas. Any gains realized from the sale of prior investments used to invest in a Qualified Opportunity Zone (QOZ) are deferred until the earlier of Dec. 31, 2026, or an inclusion event, such as the sale of the QOZ investment. Once we review the reporting of QOZ transactions, then we will review the latest news on the topic. The most recent draft of legislation on QOZs released on May 13 by the House Ways and Means Committee does not provide an extension of the current program, so deferred gains must be recognized on Dec. 31, 2026. As we approach the Dec. 31, 2026, inclusion date, it is imperative tax professionals communicate the associated tax consequences to clients who took advantage of the deferral.
Investing in a QOZ not only defers capital gains but could potentially reduce them as well. The holding period of a QOF determines the tax benefit received. The chart below outlines the additional tax benefits associated with the initial round of investments in QOFs. While deferred gains will be recognized on Dec. 31, 2026, whether the investment is sold or not, a QOF can be held beyond this date to reduce any additional gains.1
Qualified Opportunity Zones and Funds Defined
QOZs are low-income census tracts of property, as designated by the state. A state cannot designate more than 25% of low-income community tracts in the state; however, if there are fewer than 100 low-income community tracts in a state, the state may designate up to 25 tracts as QOZs. The designation of a QOZ lasts until the close of the 10th calendar year after the date of designation.2 A QOF is a corporation or partnership investing in QOZ property and filing a timely federal income tax return, including Form 8996 (Qualified Opportunity Fund) annually. QOZ property is generally QOZ stock, partnership interest or business property. The assets held by the corporation must be 90% QOZ property. If the entity fails the 90% asset test on either of the two annual testing dates (mid-year and end of year), a monthly penalty for every month out of compliance is assessed.3
Gains Eligible for Deferral
A gain eligible for deferral would otherwise be recognized for federal income tax purposes at the time of the sale, had it not been used in a QOF. Eligible gains include capital gains and qualified 1231 gains not resulting from a transaction with a related party. The gain must be invested in a QOF within 180 days of the sale, although the sale date that begins the 180-day period is not always straightforward. For example, the receipt of installment sale payments triggering a capital gain inclusion begins the 180-day period on either the date each payment is received or the last day of the taxable year. Each installment payment received can be considered a new beginning of the 180-day period for the portion of the gain attributable to each payment. Partners deferring a gain reported on a K-1 from a partnership generally use the last day of the partnership’s taxable year to begin the 180-day period. However, there is an elective rule stating a partner may choose to use either the date the sale occurred in the partnership or the due date for the partnership’s tax return without extensions.4
Process of Deferring Gains
Once a taxpayer has taxable gains from a sale, they have 180 days to invest in a QOF. Upon this investment, no capital gains will be recognized that tax year. Instead, they are fully deferred until the earlier of an inclusion event or Dec. 31, 2026. In the year a QOF investment is made, there are specific reporting requirements necessary to defer the capital gain associated. The transaction triggering the gain being deferred will be reported on either Schedule D (Capital Gains and Losses) or Form 4797 (Sales of Business Property), depending on the type of property sold. If the gain is already reported on Form 8949 (Sales and Other Dispositions of Capital Assets) or Schedule D, then an additional line on Form 8949 will be used to show the deferral. This line will include the EIN of the QOF invested in as the description in column (a) with the date of the investment in column (b). Columns (c), (d) and (e) will be left blank. Then code “Z” is entered in column (f) with the deferred gain entered as a negative adjustment in column (g). These rows can be combined if the investment is in the same QOF on the same date, even if the triggering gain comes from different sources or dates.
Reporting the deferral of a 1231 gain represented on Form 4797 requires a slightly different approach. Two separate rows must be shown on Form 8949 if the gain is a 1231 gain reported on Form 4797. The first row should have “QOF INVESTMENT FROM FORM 4797” listed in column (a) as the description of property, leaving the dates, proceeds and cost basis reported in columns (b) through (e) blank. Use code “O” in column (f) with the investment in the QOF entered as a positive adjustment in column (g). The second row will show the investment in the QOF as described previously.5
Form 8997, Initial and Annual Statement of Qualified Opportunity Fund (QOF) Investments, is used to inform the IRS of a QOF investment and deferred gains held each tax year. Recall, Form 8996 is filed by the investment to qualify as a QOF, while Form 8997 is filed by the investors showing the investments in QOFs. To properly reflect the QOF investments, Form 8997 is broken into four parts: QOF investment holding due to deferrals prior to the beginning of the year (Part I); current tax year capital gains deferred by investing in QOFs (Part II); inclusion event and certain other transfers during the current tax year (Part III); and total QOF investments due to deferrals at year-end (Part IV). Therefore, Form 8997 must be filed each year a taxpayer held a QOF investment at any time during the tax year. In the initial year of investment, the taxpayer will fill out Part II and Part IV of Form 8997. In subsequent years, the investment will remain listed on Part I and Part IV until the gain is included in income, which is reported in Part III.
Inclusion Event: Reporting the Gains
An inclusion event triggers the deferred gain recognition. As previously mentioned, this is the earlier of the sale or exchange of the QOF investment or Dec. 31, 2026. The deferred gain recognized in 2026 can be a complex calculation. One must determine the lesser of the deferred gain and the fair market value (FMV) on Dec. 31, 2026. Then this amount is reduced by the taxpayer’s basis in the QOF. Generally, a taxpayer’s initial basis in a QOF is $0 until it is increased by a 5- or 10-year basis adjustment.
There are two calculations needed when a QOF is sold to determine the gain recognized. First, the initial gain deferred is recognized. Then one must determine the basis in the investment using any basis adjustment related to the holding period of the QOF. Due to the variety of scenarios and complexity, it is best to go through some examples. Please keep in mind that these examples are simply to show the timing and calculations at the inclusion event. Other factors, such as the changes in partnership interest or debt inclusion, have not been considered. Examples 1-4 review several scenarios, each assuming the value of the QOF appreciates over time.
Example 1: QOF investment is sold before 2026 with no basis adjustment
- Original gain realized: $1 million on July 1, 2018
- Full amount invested in a QOF: $1 million on Aug. 1, 2018 (within 180 days)
- QOF investment value on Aug. 1, 2020: $1.3 million
First, the original deferred gain of $1 million is recognized. Second, there is no step-up in basis since the holding period was less than five years, so any appreciation on the investment is also recognized. Therefore, an additional $300,000 is recognized. In total, a $1.3 million gain is both realized and recognized in 2020.
Example 2: QOF investment is sold before 2026 with a basis adjustment
- Original gain realized: $1 million on July 1, 2018
- Full amount invested in a QOF: $1 million on Aug. 1, 2018 (within 180 days)
- QOF investment value on Aug. 2, 2023: $1.3 million
First, the original deferred gain of $1 million is recognized. Second, there is a step-up in basis since the holding period was greater than five years. Ten percent of the deferred gain is added to the basis ($1 million x 10% = $100,000). The adjusted basis on the exchange is now $100,000. Therefore, an additional $200,000 gain resulting from the appreciation on the QOF is recognized. While a $1.3 million gain is realized in 2023, a $1.2 million gain is recognized as taxable.
Example 3: QOF investment is sold after 2026 with a basis adjustment
- Original gain realized: $1 million on July 1, 2018
- Full amount invested in a QOF: $1 million on Aug. 1, 2018 (within 180 days)
- QOF investment value on Aug. 2, 2027: $1.3 million
First, the original deferred gain of $1 million is recognized in 2026 even though the QOF investment is still being held, but on Dec. 31, 2026, the QOF will have been held for eight years. Because the end of 2026 is deemed an inclusion event, a basis adjustment of 15% is recognized. Therefore, the step-up in basis is $150,000 (15% of $1 million gain deferred). The $1 million gain recognized less the adjustment to basis of $150,000 is then combined for a total gain of $850,000 recognized in 2026. The gain recognized in 2026 is then added to the basis of the QOF. When sold in 2027, the QOF will have been held for nine years, so no additional basis increase is necessary. When the investment is sold, the basis is $1 million ($150,000 adjusted basis + $850,000 gain recognized in 2026). The $1.3 million proceeds less the $1 million adjusted basis results in a gain of $300,000 recognized in 2027. Over the years, a $1.3 million gain is realized, but only $1.15 million is recognized.
Example 4: QOF investment is sold after 2026 with a basis adjustment (10 years)
- Original gain realized: $1 million on July 1, 2018
- Full amount invested in a QOF: $1 million on Aug. 1, 2018 (within 180 days)
- QOF investment value on Aug. 2, 2028: $1.3 million
First, the original deferred gain of $1 million is recognized in 2026 even though the QOF investment is still being held, but on Dec. 31, 2026, the QOF will have been held for eight years. Because the end of 2026 is deemed an inclusion event, a basis adjustment of 15% is recognized. Therefore, the step-up in basis is $150,000 (15% of $1 million gain deferred). The $1 million gain recognized less the basis adjustment of $150,000 is then combined to be a total gain of $850,000 recognized in 2026. This gain recognized in 2026 is then added to the basis of the QOF.
When sold on Aug. 2, 2028, the QOF investment will have been held for 10 years. A QOF that is held for more than 10 years is eligible to adjust the basis to FMV on the date of sale. With this election, the adjusted basis on the exchange is now $1.3 million, resulting in $0 capital gain recognized in 2028. Over the years, a $1.3 million gain is realized but only $850,000 is recognized.
Examples 5-6 run through similar scenarios, except the value of the QOF depreciates over time, resulting in a loss.
Example 5: QOF investment is sold before 2026 (depreciated in value)
- Original gain realized: $1 million on July 1, 2018
- Full amount invested in a QOF: $1 million on Aug. 1, 2018 (within 180 days)
- QOF investment value on Aug. 2, 2024: $500,000
When sold on Aug. 2, 2024, the lesser of the FMV or the deferred gain is $500,000 because the investment depreciated in value. The adjusted basis in the asset is $100,000 ($0 initial basis + 10% increase on $1 million deferred gain). The deferred gain recognized in 2026 is $400,000 ($500,000 - $100,000).
Another approach to calculating this gain is to look at the sale in two parts. The initial basis is $100,000 because the investment was held for six years. Therefore, the deferred gain recognized in 2024 would be $900,000 ($1 million originally deferred gain less 10% basis adjustment). The second part of the calculation is the loss calculation. The basis is $1 million ($100,000 adjusted basis + $900,000 deferred gain recognized). If sold for $500,000 with a $1 million basis, the loss recognized is $500,000. In total, a gain of $900,000 and a loss of $500,000 is recognized in 2024, resulting in a net gain of $400,000.
Example 6: QOF investment is sold after 2026 (depreciated in value)
- Original gain realized: $1 million on July 1, 2018
- Full amount invested in a QOF: $1 million on Aug. 1, 2018 (within 180 days)
- QOF investment value on Dec. 31, 2026: $600,000
- QOF investment value on Aug. 2, 2027: $500,000
On Dec. 31, 2026, the lesser of the FMV or the deferred gain is $600,000 because the investment depreciated in value. The adjusted basis in the asset is $150,000 ($0 initial basis + 15% increase on $1 million deferred gain). The deferred gain recognized in 2026 is $450,000 ($600,000 - $150,000). When sold in 2027, the basis in the QOF will be $600,000 ($0 initial basis + $150,000 basis adjustment + $450,000 gain recognized in 2026). The $500,000 proceeds are reduced by the basis of $600,000. Thus, the loss recognized in 2027 is $100,000.
What Is on the Horizon?
On May 13, the House Ways and Means Committee released a draft of the One Big Beautiful Bill Act, and tax professionals everywhere began combing through it. While the bill will likely go through many changes before being approved in its final form, it provides a landscape to begin planning. No extension of the current QOF program ending on Dec. 31, 2026, was provided. Instead, a new round of Opportunity Zone designations will begin on Jan. 1, 2027, lasting through Dec. 31, 2033. Several adjustments from the original Opportunity Zone program are included in the draft bill, such as:
- Reducing the income threshold for census tracts qualifying to 70% of median family income rather than the previous 80%.
- Twenty-five percent of the state’s eligible tracts may be designated, but there is a focus on rural areas. Of the 25%, the greater of a third of the designations or the state’s rural population share must be entirely rural.
- The step-up basis adjustment is now 10% after five years. A special rule for rural opportunity funds allows a step-up of 30% in five years.
- Ordinary income deferral is allowed and eligible for the 10-year exclusion, but no 5-year step-up in basis. Up to $10,000 of ordinary income per year with a lifetime limit of $10,000 per taxpayer is authorized for deferral in a QOF.6
In conclusion, the original QOZ initiative created many capital gain deferrals and incentivized investing in low-income areas. However, the current deferral period is quickly coming to a screeching halt. With no extension of the current program provided in the draft legislation, taxpayers need to be aware of the additional gains or losses to be recognized in 2026 in order to plan properly. Tax planning, such as loss harvesting, should be discussed in detail. Cash may need to be raised since there may be a significant gap in time between when the tax on gains is assessed and proceeds are received. There are so many unknowns and tax reforms coming our way, and while nothing is certain at this point, taxpayers should prepare to recognize their deferred QOZ gains in 2026.
About the Authors
Shelby Follis, CPA, is a tax manager at LBMC. She can be reached at shelby.follis@lbmc.com.
Emily Cokeley, Ph.D., CPA, is an assistant professor at East Tennessee State University. She can be reached at cokeley@etsu.edu.
References
1Pedowitz, F. (2021). Frequently asked questions about opportunity zones. RSM. https://rsm.us/3FqxK7D
2115th Congress. (n.d.). 26 USC 1400Z–1. PUBLIC LAW 115–97—DEC. 22, 2017.
3IRS. (2022). Opportunity Zones. Retrieved from irs.gov/newsroom/opportunity-zones: https://bit.ly/irsoppzone
4United States Congress. (n.d.). Internal Revenue Code. 26. U.S.C. § 1400Z-2. 2018 ed.
5IRS. (2024). Instructions for Form 8949.
6Atkinson, J. (2025). Opportunity Zone Legislation Advances, But Misses The Mark. OpportunityZones.com.
This article was originally published in the July/August 2025 Tennessee CPA Journal.
