The December 31, 2026 Opportunity Zone Inclusion: When a Lower Valuation Helps and When It Does Not

As part of our July article, Opportunity Zone 2.0 Is Coming: What Existing OZ Investors Should Be Doing Now, we discussed the December 31, 2026, recognition date carried over from the original Opportunity Zone program. That date is now just a few months away. As previously discussed, an investor still holding a Qualified Opportunity Fund (QOF) interest on December 31, 2026, generally must determine and recognize the amount of deferred gain required under the statutory inclusion formula, even if there is no sale, closing, or cash distribution from the fund.

This article focuses on one year-end planning consideration: an investor whose fund has lost value may recognize less than the full deferred gain on December 31, 2026. For projects still under construction, behind on lease-up, or otherwise worth less than cost, the potential benefit may be significant. But before commissioning an appraisal, investors should determine whether other rules may reduce or eliminate that benefit. For example, investors in QOF partnerships, including many real estate funds, must account for the special hypothetical-sale calculation.

How a Lower Valuation Can Reduce the 2026 Tax

Under the general rule, the investor recognizes the excess of the lesser of the applicable deferred gain or the fair market value of the qualifying QOF investment over the investor’s adjusted basis in that investment. For investments held through December 31, 2026, basis may include the applicable five-year or seven-year basis increase, as well as other adjustments permitted under the regulations. The 10% five-year increase generally is available only for investments made sufficiently early to satisfy the five-year holding period by December 31, 2026, while the additional 5% seven-year increase effectively required an investment by the end of 2019. If the investment’s value has declined, the amount recognized on December 31, 2026, may be less than the remaining deferred gain. The potential benefit extends beyond timing. If the investment later recovers and the investor ultimately makes a valid ten-year fair-market-value basis election upon a qualifying disposition, the resulting basis adjustment may eliminate gain attributable both to post-2026 appreciation and to the recovery of value that was not taken into account in the 2026 inclusion calculation.

The relevant asset is the investor’s fund interest, not a proportionate share of the fund’s underlying real estate. Reported net asset value therefore may not establish fair market value for federal tax purposes. Depending on the facts, the value of the fund interest may differ because of restrictions on control and liquidity and risks affecting the underlying projects, including construction, lease-up, and financing risks.

The Limit That Applies to QOF Partnerships

QOF partnerships are subject to an important limitation. Instead of considering only the equity value of the fund interest, the regulations measure the gain the investor would recognize on a hypothetical sale at fair market value. Because the amount realized includes the investor’s share of partnership liabilities, the investor may recognize substantial gain even when the interest’s equity value has declined. A modified passthrough calculation also applies to a qualifying investment in a QOF S corporation. Unlike the partnership calculation, however, the shareholder’s amount realized does not include a share of entity-level liabilities under Code Section 752. The liability-driven result described below therefore is principally a partnership issue.

Prior distributions and allocated losses may reduce basis, while the investor’s share of partnership debt remains included in amount realized. This combination is common in real estate funds that have refinanced property and distributed the proceeds or generated substantial depreciation deductions. In those cases, the hypothetical-sale gain may remain high even when the equity value has fallen.

Consider an investor who deferred $1,000,000 and qualifies for a $100,000 basis adjustment. On December 31, 2026, the investor’s QOF interest is worth $400,000. Under the general rule, the investor recognizes $300,000: the $400,000 value less the $100,000 basis adjustment. Now assume the QOF is a partnership, the investor previously received a $600,000 debt-financed distribution, the investor is still allocated $600,000 of partnership debt, and the investor has $100,000 of outside basis immediately before the hypothetical sale. The investor’s amount realized includes both the $400,000 equity value and the $600,000 of debt relief. After subtracting the $100,000 basis, the investor has $900,000 of hypothetical-sale gain. The hypothetical-sale gain therefore equals the investor’s $900,000 remaining deferred gain, requiring recognition of the full $900,000 on December 31, 2026. Same appraised equity value. $600,000 more income. The hypothetical-sale calculation determines the amount of deferred gain included. The character and other attributes of the included gain generally continue to be determined by reference to the originally deferred gain.

Other Year-End Considerations

Two related issues also deserve attention.

First, distributions or other transactions that reduce the investor’s direct or indirect equity interest may trigger gain before December 31, 2026, and may reduce the portion of the investment eligible for the ten-year election. Sponsors considering distributions to help investors fund the 2026 tax liability should model the consequences before making the payment.

Second, investors in underperforming projects should consider whether remaining invested is the right strategy. Investors who expect the project’s value to recover and intend to hold long enough to make the ten-year election may obtain a permanent benefit from supporting a lower 2026 value. If the investor sells before the election becomes available, however, some or all of the 2026 benefit may return as additional gain on the sale.

Investors with limited expectations of recovery may instead prefer to redeploy capital. A sale or other separate inclusion event before December 31, 2026, may produce eligible gain that begins a new 180-day investment period, provided the gain and the new investment satisfy the otherwise applicable requirements. By contrast, the mandatory inclusion occurring solely because of the December 31, 2026, statutory deadline cannot itself be reinvested to obtain another deferral. Notice 2026-40 confirms that eligible gain realized on or before December 31, 2026, may, if the 180-day period remains open, support a qualifying investment made on or after January 1, 2027, under the amended Opportunity Zone rules. The investor would give up the ten-year election for the portion sold, but the new investment would begin its own holding period.

Practical Steps Before Year-End

The first question is whether a lower valuation would change the result. For a leveraged QOF partnership, it may not. Investors and sponsors can often answer that question by reviewing the fund structure, prior distributions and losses, tax basis, and liabilities reported on Schedule K-1. If value still matters, they should promptly engage an appraiser and gather current financial statements, debt balances, projections, and information about pending financings, leases, sales, or construction milestones. The valuation date is December 31, 2026, although the appraisal may be finalized afterward.

Investors and sponsors should begin now. Qualified appraisers may face significant year-end demand, and much of the work can be completed in advance and updated once year-end facts are known. A coordinated fund-level valuation process also may be more efficient than separate appraisals for each investor. Any coordinated process should account for differences among classes, investor-specific rights, transfer restrictions, and other terms that may cause the fair market value of particular interests to differ from a simple proportionate allocation of fund-level net asset value.

An investor reporting less than the full deferred gain should be prepared to substantiate the value used. Although no appraisal is expressly required, a contemporaneous valuation may provide important support. Particular care is warranted if the investment’s value increases materially shortly after year-end. A later financing, lease, sale, construction milestone, or similar event may invite scrutiny if it reflects facts, negotiations, or market expectations existing and known or reasonably knowable on December 31, 2026. The appraisal should distinguish valuation-date information from genuinely subsequent developments and explain whether any later event corroborates conditions existing on the valuation date.

Bottom Line

A decline in value may reduce the 2026 tax, but not for every investor. For a leveraged QOF partnership, prior distributions, tax basis, and allocated liabilities may matter more than the appraised equity value.

Investors should determine now whether a lower valuation would change the inclusion amount and whether they expect to hold long enough to make the ten-year election. If valuation matters, they should promptly engage an appraiser and assemble the information needed to support the December 31, 2026, value.

Facing questions about your OZ project? Reach out to Robert Garner, Alice Lin, or another member of LP’s Tax Planning Group.