Options to Reduce Capital Gains in an Opportunity Zone Investment
By William Sherbert, Principal of Sherbert CPA PC, bsherbert@sherbertcpa.com
Opportunity Zone (OZ) investments, introduced under the 2017 Tax Cuts and Jobs Act, have offered a powerful way for investors to defer and potentially reduce or eliminate capital gains taxes by reinvesting eligible gains into Qualified Opportunity Funds (QOFs) that target economically distressed communities. OZ investors have a looming deadline: deferred capital gains from original investments must be recognized by December 31, 2026 (or earlier if the QOF interest is sold/exchanged), with taxes due when filing the 2026 tax return in 2027.
This mandatory inclusion event applies to OZ 1.0 investments (those made by December 31, 2026). While the program has evolved – with updates under recent legislation making aspects permanent starting in 2027 – the focus here is on strategies to reduce the taxable amount of these deferred gains in 2026.
There are two primary methods to lower the recognized capital gain amount:
- Basis Step-Up Reductions (10% or 15%) — These depend on when the original investment was made and how long it was held before the 2026 deadline.
- If the QOF investment was held for at least 5 years (requiring investment by roughly the end of 2021), investors receive a 10% step-up in basis on the deferred gain, effectively reducing the capital gain by 10%.
- If held for at least 7 years (requiring investment by roughly the end of 2019), this increases to a 15% step-up (10% + an additional 5%), effectively reducing the capital gain by 15%.
These benefits phased out for later investments, so many recent OZ participants don’t qualify for any step-up. The step-up permanently reduces the deferred gain amount included in income in 2026.
- Fair Market Value (FMV) Limitation — This is often the most overlooked and potentially powerful reduction for underperforming investments. On December 31, 2026, the amount of deferred gain recognized is the lesser of:
- The original deferred capital gain amount (adjusted for any prior step-up), or
- The FMV of the QOF investment on that date (minus any adjusted basis in the investment, which is typically low or zero unless a step-up applied).
Many investments made in 2019 – 2021 have not done as well as anticipated, due primarily to increased project costs due to Covid delays and the following spike in inflation. As a result, the investment in these projects may be currently underwater. OZ investors should consider analyzing the fair market value of their investment to see if they can obtain a reduction in capital gain in 2026.
If the QOF investment’s value has declined below the original invested amount (e.g., due to market conditions, project delays, or other factors), the FMV may be lower than the deferred gain. In that case, the taxable recognized gain is capped at the lower FMV figure—potentially reducing or even eliminating the tax bill on the deferred amount.
The brilliant aspect of this method is its interaction with the program’s long-term benefit: If you continue holding the QOF investment for at least 10 years from the original investment date, any post-investment appreciation (or recovery in value) can qualify for permanent exclusion from capital gains tax upon sale or exchange. This means:
- You recognize only the reduced (or zero) deferred gain in 2026 based on the low 2026 FMV.
- Future growth in the investment – including any rebound from the 2026 low point is tax-free if held long enough.
This creates a “best of both worlds” scenario for investments that temporarily dipped: minimize 2026 taxes via the FMV rule, then capture unlimited upside, including FMV recovery, tax-free so long as you meet the 10-year hold. Note that proper FMV determination requires a defensible valuation (often via appraisal), and this applies even if the investment later recovers.
In summary, while the 10% and 15% basis step-ups were valuable for early investors, the FMV-based reduction stands out as especially advantageous in 2026 for any OZ investment that hasn’t performed as hoped. By leveraging a lower 2026 valuation to shrink the deferred gain inclusion—and then holding for 10+ years to exclude future appreciation—investors can dramatically lower their overall tax burden while still benefiting from community-focused development.
Opportunity Zones remain complex, with nuances depending on individual circumstances, holding periods, and potential state taxes. The program continues in modified form (OZ 2.0) after 2026 with rolling deferrals and other incentives.
The Sherbert Group is here to help you with any personalized guidance or analysis that is needed, as rules can involve specific elections, valuations, and compliance requirements.