Planning for the 2026 opportunity zone deferral benefit expiration – cashless gain

Opportunity zones (OZs) were created under The Tax Cuts and Jobs Act (TCJA) to incentivize investment in distressed areas of the country. To do this, the OZ program offered investors a couple of key tax benefits. First, investors who reinvested the proceeds of an investment sale into a Qualified Opportunity Zone (QOZ) fund could defer gain from that sale until Dec. 31, 2026. Second, the OZ program allows investors who hold their OZ fund investment for at least 10 years to permanently exclude any gain on that investment.

While OZ investments have been great way for investors to make tax-efficient investments into distressed areas of the U.S., investors must not forget about the coming tax due on their original deferred gain. Investors who may have realized a “cashless” gain up to eight years ago might not remember that this gain was deferred rather than eliminated. Proper planning can help mitigate this recognition event, but it requires proactive collaboration with your advisors.  

To further this point, here is an example:

An investor owned stock in XYZ public company. In 2018, the investor sold XYZ and deferred $1,000,000 of capital gain by reinvesting the proceeds in an OZ fund that purchased property in a QOZ for $1,000,000. This investment allowed the investor to defer taxation on the $1,000,000 gain until 2026. 

In the 2026 tax year, the $1,000,000 gain is recognized and subject to a current tax rate of 23.8%, resulting in a federal tax of $238,000, plus any potential state income tax. For investors to receive full benefits of the OZ program, they need to leave their $1,000,000 investment in the OZ fund for at least 10 years. This creates a problem for an investor who faces a tax bill on capital that is inaccessible.

The following are current planning opportunities to consider if you hold an OZ investment and want to lessen the burden of your upcoming tax bill:

• Defer tax loss harvesting strategies in 2025 and harvest those losses in 2026. These losses will offset the capital gain recognition that will be triggered in 2026.
• Since the gain recognition will occur as a 2026 tax item, the last date the tax would be due on this recognition would be April 15, 2027. Plan now to ensure you have sufficient liquidity for this future tax bill. Your advisor can help coordinate the liquidity and tax strategy. 
• Investors in OZ funds pay tax on the lesser of previously deferred gains or the fair market value of their equity. If the OZ investment has declined in value, this may create an opportunity for the investor to reduce their tax bill by using the fair market value of their investment to calculate their 2026 tax liability. The Baker Tilly valuation team can assist with substantiating the valuation for tax purposes.