As companies plan for recognition of opportunity zone (OZ) deferred capital gains effective Dec. 31, 2026, now’s the time to focus on planning opportunities involving valuation discounts. Valuation comes into play with respect to OZ deferred gain recognition because the Internal Revenue Code (IRC) requires investors in qualified opportunity funds (QOFs) to reduce the amount of deferred gain recognized on Dec. 31, 2026, to the extent that the fair market value (FMV) of their QOF investment is lower than their original deferred gain.
The FMV of a QOF investment can decline for numerous reasons, most obviously because the value of the underlying business has declined. However, several valuation discounts can also contribute to such a decline, specifically these three discount types: lack of marketability (DLOM), lack of control (DLOC), and risk associated with real estate under construction.
Statutory deferred gain recognition calculation
QOF investors must recognize deferred capital gains on Dec. 31, 2026, unless the gain is required to be recognized earlier due to an inclusion event, such as a sale. IRC Section 1400Z-2(b)(2)(A) provides that the amount of deferred gain recognized on Dec. 31, 2026, is calculated based upon the lesser of the following:
- The original deferred gain.
- The FMV of the QOF investment on Dec. 31, 2026.
The “lesser of'” provision is taxpayer-favorable and technically required. However, the IRS won’t ask taxpayers to support the FMV of their QOF investment if they report the original deferred gain as income on their 2026 tax return.
In all events, gain is only recognized to the extent such amount exceeds the taxpayer’s basis in the QOF investment. Under IRC Section 1400Z-2(b)(2)(B)(i), the taxpayer’s basis in the QOF investment is generally zero. However, such basis is increased by the following:
- Any 10% or 15% basis increase earned by the QOF investor for holding their QOF investment for at least five or seven years, respectively.
- Deferred gain recognized prior to Dec. 31, 2026, due to an inclusion event.
IRS definition of fair market value
The IRC doesn’t provide for a unique definition of FMV for OZ purposes. Consequently, the IRS’ general definition of FMV applies to the OZ provisions in the IRC. FMV is generally defined by the IRS in Revenue Ruling 59-60 as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of relevant facts.”
Valuing opportunity zone investments in real estate
The majority of OZ investments have been used to develop real estate projects. The FMV of a QOF investment in real estate is dependent upon the FMV of the project, which will vary depending on the stage of the development. Since rental real estate is generally valued based on stabilized net operating cash flows, completed and stabilized projects can be valued more precisely than projects that are under construction, which are subject to valuation discounts due to uncertainties and risks, including:
- Construction and completion risk — execution, entitlement and regulatory, and financing risks.
- Lease-up and market risk — no cash flow, absorption risk, and exposure to market cycle risk.
- Time value of money.
- Liquidity and financing constraints.
When valuing mid-construction projects, appraisers conduct thorough market research to understand how buyers evaluate properties in various scenarios, including incomplete developments, distressed or halted development projects, estate-related settlements, and assets with complex ownership and entitlement issues. This research indicates that buyers generally require pricing discounts when acquiring properties in a mid-construction state to compensate for the elevated risks assumed at that stage. Such risks include construction and completion uncertainty, lack of operating income, leasing and market absorption risk, and other development‑related uncertainties, consistent with the risks outlined above.
Completed real estate development projects could also be eligible for a reduction in deferred gain required to be recognized on Dec. 31, 2026, to the extent that the project has lost value relative to cost or is underperforming.
Appraiser’s approach to valuing real estate under construction
Consistent with the valuation principles outlined in Revenue Ruling 59‑60, appraisers typically estimate the FMV of properties under construction using an analytical framework that considers the relationship between stabilized value, remaining development risk, and capital structure. This framework is often expressed conceptually as:
- Estimating the stabilized FMV of the property upon completion using the income, sales comparison, and/or cost approaches, as applicable.
- Deducting all remaining costs to complete construction and achieve stabilization.
- Reflecting construction‑stage risk through an appropriate adjustment, resulting in a gross asset value.
- Subtracting outstanding debt to derive the net asset value of the ownership interest.
This framework isn’t a specific or prescribed valuation formula under the Uniform Standards of Professional Appraisal Practice (USPAP) or other appraisal standards. Rather, it represents a market‑derived construct that has evolved from observed pricing behavior in transactions involving properties transferred during the construction phase, including direct real estate sales and transfers of partnership or entity interests holding development projects. Importantly, construction‑stage risk may be reflected through various valuation mechanisms depending on the assignment and market evidence, including explicit discounts, adjustments to projected cash flows, or selection of higher discount rates or capitalization assumptions, rather than through a single, uniform adjustment.
Additional discounts for lack of control and marketability
Since the OZ incentive requires investments to be made into a domestic legal entity, additional discounts may apply to the extent that the investor is subject to limitations on their ability to control and/or transfer their interest in the QOF and/or to the extent that the QOF is subject to similar limitations with respect to its investment in a qualified opportunity zone business (QOZB). This reflects the fact that buyers typically pay less to acquire an interest in an entity than they would pay to acquire the assets of the entity when the ownership interest is subject to restrictions. Such discounts include:
- Discount for lack of control (DLOC) refers to a reduction in value of a minority interest because the member/shareholder can’t influence major decisions.
- Discount for lack of marketability (DLOM) reflects the reduction in value applied to an ownership interest in a business due to the absence of a ready market for the interest. It accounts for the difficulty or inability to quickly sell or convert the interest into cash without a significant loss in value.
DLOC or DLOM will be determined based on the facts and circumstances of each case. The IRS has discussed the relevant authorities associated with DLOM in a publication, “Discount for Lack of Marketability: Job Aid for IRS Valuation Professionals,” Sept. 25, 2009.
The important point is that the application of DLOC and DLOM has the potential to further reduce the value of the QOF and QOZB’s assets in arriving at FMV of the QOF investment.
Regulatory restrictions on valuation discounts
The Treasury Department has issued regulations providing guidance to assist QOF investors in calculating the amount of deferred capital gain to be recognized on Dec. 31, 2026. Treasury Regulation Section 1.1400Z2(b)-1(e)(4) provides a “special amount includible rule” for partnerships and S corporations. Such regulation may reduce or eliminate the benefit of a low valuation to the extent that a partner or S corporation shareholder has received distributions or cumulative loss allocations and an allocation of liabilities on their 2026 Schedule K-1.
For example, these circumstances could occur when a new loan is placed on a property and there are net proceeds available to be distributed. This provision also comes into play when a QOF investor has received allocations of tax losses and debt on its Schedule K-1, which isn’t uncommon for investments in operating businesses and completed real estate projects, particularly due to cost segregation studies or bonus depreciation. Such QOF investors should consult their tax advisor as soon as possible regarding the impact of this regulatory guidance. Doing so could help QOF investors avoid paying for an appraisal that’s not beneficial and plan for the negative impact of this regulation. Additional details regarding this regulatory provision and related planning considerations are available in our separate article, “OZ deferred gain valuation discounts: Beware of the fine print.”
Valuation documentation
The tax law doesn’t require QOF investors to obtain an appraisal to support the reduction of deferred gain due to a decline in the value of their investment. However, where discounts are significant, taxpayers should strongly consider obtaining contemporaneous third-party documentation to support their tax position and be able to defend against an IRS challenge. The best form of documentation is a contemporaneous appraisal from a qualified appraiser of the QOF interest. An appraisal of the QOZB’s assets could be helpful, but additional analysis will be necessary to reconcile the value of the QOZB’s assets to the value of the investor’s interest in the QOF, including consideration of the QOZB and QOF’s cash flow waterfall, DLOC, and DLOM.
Taxpayers that have made eligible investments in a third-party QOF, or whose QOF has made an investment in a third-party QOZB, should coordinate with the organizer of the QOF/QOZB regarding valuation documentation if they believe that the value of their investment in the QOF may be lower than their investment. The organizer of the QOF/QOZB may be able to provide information to help support the valuation of the QOF investment, which could be much more efficient than each individual investor obtaining their own documentation. Although the QOF/QOZB organizer may appear to be conflicted with respect to providing information supporting a decline in value of the QOF/QOZB investment, QOF investors should keep in mind that the goal of such valuations is to reduce the amount of tax required to be paid on deferred capital gains recognized on Dec. 31, 2026, and that most such valuations will reflect discounts that will ultimately not come into play when the QOF investor ultimately liquidates its investment in the QOF.
Considering that every taxpayer who invested in a QOF during the nine-year period from 2018 through 2026 could potentially need an appraisal or valuation of their QOF investment as of Dec. 31, 2026, qualified appraisers are likely to be at a premium as we get closer to the end of 2026 and the April 15, 2027, tax reporting/payment deadline. As such, QOF investors should start the process of obtaining third-party documentation of the value of their QOF investment as soon as possible. In many cases, a portion of the analysis and documentation can be done in advance of the Dec. 31, 2026, valuation date (e.g., DLOC and DLOM), which will help avoid a last-minute fire drill and could reduce costs. Appraisers can also use a phased approach to help QOF investors plan for the Dec. 31, 2026, gain recognition event and spread out the work to control cost. In particular, the first phase can estimate the value of the QOF investment based on anticipated facts as of Dec. 31, 2026, and the second phase can true up the valuation based on the actual facts.
Opportunity zone 1.0 valuation discounts vs. opportunity zone 2.0 enhanced tax benefits
The One, Big, Beautiful Bill Act (OBBBA) improves the incentive for investing capital gains into a QOF on or after Jan. 1, 2027. In particular, such OZ 2.0 investments receive a rolling five-year deferral and 10% reduction of invested capital gains, if the investor holds its interest in the QOF for five full years. QOF investors with the flexibility to make a QOF investment either before or after the Jan. 1, 2027, cutoff date for OZ 2.0 should consider how the FMV component of the deferred gain recognition calculation may impact the amount of deferred gain required to be recognized on Dec. 31, 2026, if the QOF investment is made under OZ 1.0. Depending on the facts and circumstances, it could be more advantageous for a QOF investor to make the investment in the QOF by Dec. 31, 2026, under OZ 1.0 and forgo the OZ 2.0 five-year deferral and 10% reduction. For example, if a real estate project is expected to be under construction on Dec. 31, 2026, the tax benefit of the valuation discount associated with the construction and lease-up risk of such project combined with DLOC and DLOM could be more valuable than the five-year deferral and 10% reduction that the investor would receive for delaying their QOF investment into 2027.
Key takeaways
- QOF investors should be aware of the opportunity to reduce the deferred capital gain that they’re required to recognize on Dec. 31, 2026.
- They should act quickly to initiate the process of obtaining contemporaneous third-party documentation supporting applicable discounts in the FMV of their QOF investment, including DLOC and DLOM.
- The value of real estate projects under construction on Dec. 31, 2026, will also be discounted to account for the risks of completion, lease-up, and market conditions, while tying up capital that produces no current income.
- However, before engaging an appraiser to value an investment in a QOF structured as a partnership or S corporation, QOF organizers and investors should consult their tax advisor if the QOF investors have received distributions and/or cumulative loss allocations that were directly or indirectly financed by debt since a special regulatory provision may reduce or eliminate the benefit of a low valuation in those situations.
