Why this matters more now
For years, the IRS had little reason to look closely. That is changing as original investors recognize their gains and funds reach the ten-year mark, when the tax-free exit is worth the most. As Ashley puts it, "Up till now, the IRS hasn't had really a dog in the fight. But as we go into filing for December 31st, 2026, now the IRS has the ability to be able to go back."
The 2025 law also added detailed fund reporting with daily penalties. Here are the traps we see most, each tied to the rule behind it.
1. The first Form 8996 was late
A fund certifies itself by filing Form 8996 with a timely return, including extensions (Treas. Reg. 1.1400Z2(d)-1(a)(2); IRS FAQ 38). Miss the first one and the entity may not be a fund at all, which puts every investor's deferral at risk. The fix is usually a private letter ruling for late-election relief. See missed Form 8996.
2. An investor skipped Form 8997
Investors must report every qualifying investment every year they hold it. Skip a year and the regulations presume an inclusion event happened that year (Treas. Reg. 1.1400Z2(a)-1(d)(2)). You can rebut the presumption, but you have to prove it. File it every year, including years when nothing changed.
3. Cash was sitting in the fund on a test date
The fund needs 90% of its assets in Opportunity Zone property on its two test dates. New cash can be left out only for about six months and only if it stays in cash or short-term debt. After that, idle cash in the fund counts against you, and the penalty is figured for each month you are short (IRC 1400Z-2(f)). Move the money into the QOZB before the test. See the forms guide.
4. The property was bought wrong
Opportunity Zone business property has to be bought from an unrelated person, using a more-than-20% ownership test. Property contributed for equity does not count as bought. Property closed in another entity and moved over later can fail the same test. Ashley's warning: "Do not close on a property in an entity that's not a QOZB."
5. The working capital plan and the spending do not match
A QOZB can hold cash for up to 31 months only if the cash is designated in writing for the project, there is a written schedule, and the money is actually used in a way that substantially matches the plan (Treas. Reg. 1.1400Z2(d)-1(d)(3)(v)). Without that, idle cash is nonqualified financial property, and more than 5% fails the QOZB. For projects in original zones that did not make the new map, Notice 2026-40 says the IRS intends to propose hard December 31, 2026 conditions. These rules come from IRS Notice 2026-40, which describes regulations the IRS plans to propose. Confirm the current status with your advisor before acting. See the working capital plan deadline.
6. The building was not substantially improved in time
A used building has to be substantially improved: within any 30-month period after purchase, you add more than its adjusted basis, or more than 50% in a rural zone. Land does not count toward the building's basis, and unimproved land does not need to be improved. Ashley's practice is to put a certificate of compliance with substantial improvement in the file once the test is met.
7. A distribution went above basis
In a fund taxed as a partnership, a distribution above your basis in the qualifying investment is an inclusion event (Treas. Reg. 1.1400Z2(b)-1(c)(6)(iii)). Refinance proceeds are the usual cause. See distributions vs. allocations.
How to stay out of trouble
Ashley's line is the summary: "You don't have to ask for permission from anybody, but you better have a dang good audit trail." Keep balance sheets for every test date, the dated working capital plan and receipts against it, closing documents showing an unrelated seller, each year's Forms 8996 and 8997, and the QOZB's data for the new reporting.
Our compliance services build and keep that file. For a review of a fund you did not set up, start with a 15-minute call.