Insulated rail signal works properly when track power is not applied.

OPTION B – If the optical sensor is covered with black tape, then the input
(YELLOW) wire can be used to control the sensor. Connecting the input wire
to an isolated rail will cause the sensor to change its two outputs and operate
a typical LED signal.

Did you remember to cover the sensor with black elect tape? - this is my guess

Did you connect the yellow wire to the track?

Joe

Yes and yes.

If you use one transformer to power the track, and a second transformer to power the DZ1075, then the two transformers must have their outputs in phase, and must have their grounds outputs (like the U terminal on most transformers) connected together.

I'm running everything off on one Z4000.
The signal is powered by the 14 volt accessory circuit.

My last thought still has to do with powering the track and the DZ1075. The ground of the track power output of the Z4000 must go to the outer rail of your layout, and the ground of the accessory output of the Z4000 must go to the ground of the DZ1075 (DZ1075's black wire).

If, as I suspect, the track outer rail and the DZ1075 are not connected to the Z4000 black terminals, the reason why it works with track power full off is that I believe the Z4000 grounds the its red track output with full off throttle - necessary for correct proto operation.