The original pitch was to invest your capital gains into an OZ fund, defer the tax, and if you hold for ten years, pay no tax on the appreciation. Some tech founders and VCs used this after exits, rolling six- and seven-figure gains into real estate development funds in designated zones. It's easy to lose sight of a future tax bill when no cash is changing hands, but the bill is coming.
The gain will be recognized on December 31, 2026, with taxes due when you file your 2026 return. The amount recognized is generally the lesser of your deferred gain or the investment's fair market value minus basis. You don't need to sell or receive a distribution. If the fund is still holding illiquid real estate, you may owe the tax without receiving a distribution. There is a partial offset. Depending on when you invested, the IRS gives you a 10% or 15% basis step-up, which on a $1 million deferral can reduce the taxable portion by $100,000 to $150,000.
Even with the step-up, a $1 million deferral can still produce a federal tax bill north of $200,000 between the 20% capital gains rate and the 3.8% net investment income tax.
Most OZ funds are in real estate, and performance has varied widely depending on when capital was deployed and how interest rates moved thereafter. Investors should not assume the fund will distribute cash in time to cover the 2026 liability.
Harvesting capital losses elsewhere in your portfolio during 2026 is the most direct offset. If the OZ property is completed and in service, a cost segregation study may generate deductions or losses that could help offset other income, depending on structure and tax profile. The ten-year hold for tax-free appreciation on the fund's growth is still available. But the original deferred gain comes due regardless.
For educational purposes only. Not tax, legal, or investment advice.