By Jeffrey J. Schrader, CPA, MST
If you own unimproved or vacant land as an investment, there is an election under Internal Revenue Code Section 266 to capitalize expenses generated by the investment property. This may offer a solution to having lost certain deductions due to the Tax Cuts and Jobs Act (TCJA). In this blog, we explore the election and how it may offer a remedy to lost tax breaks.
Section 266 Election
Under Section 266, the IRS allows taxpayers to capitalize taxes, interest, and carrying charges that would otherwise be deducted or lost. This election provides flexibility, is made on a year-by-year basis, and allows for the capitalization of any or all three categories of expenses—taxes, interest and carrying charges.
Under TCJA, many taxpayers now claim the increased standard deduction instead of itemizing as they may have done in the past. But for those still electing to itemize, there is the $10,000 limitation on the state and local tax deduction. Further, all miscellaneous 2% of adjusted gross income (AGI) deductions are no longer deductible under the TCJA, meaning taxpayers can no longer deduct the investment expenses and other carrying charges related to investment property. To offset these lost deductions arising from the new tax law, a Section 266 election could possibly be made to add those expenses to the basis of the property, resulting in a smaller capital gain (and lower taxes) upon the sale of the property.
Can the Election Be Made?
The AICPA isn’t sure if a Section 266 election is still valid under TCJA, and is seeking clarity. For reference, here is what Section 266(b) says, in part:
The taxpayer may elect, as provided in paragraph (c) of this section, to treat the items enumerated in this subparagraph which are otherwise expressly deductible under the provisions of Subtitle A of the Code as chargeable to capital account either as a component of original cost or other basis, for the purposes of section 1012, or as an adjustment to basis, for the purposes of section 1016(a)(1). The items thus chargeable to capital account are:
(i) In the case of unimproved and unproductive real property: Annual taxes, interest on a mortgage, and other carrying charges.
In a letter from June 5, 2019, to the IRS regarding Recommendations for the 2019-2020 Guidance Priority List, the AICPA asked the following:
“Provide guidance on whether the annual election under section 266 to capitalize taxes and carrying charges of investment property (previously a 2% miscellaneous itemized deduction), in lieu of deducting the expense, remains available for taxpayers owning real estate – noting that section 266 requires an otherwise deductible expense.”
To date, the IRS had not responded to this specific query.
Certainly, the taxes and interest would qualify under the election (see further options for the treatment of interest and taxes below). But what about other investment expenses/carrying charges—formerly miscellaneous itemized deductions subject to the 2% AGI limit—which are now expressly not deductible under the TCJA? Are they now ineligible to be capitalized? The CPA community needs definitive guidance.
If itemizing, taxpayers should consider the following options:
- Interest paid on money borrowed to purchase and hold land acquired for investment purposes is investment interest. It is deductible, subject to the investment interest limitation. Even with the limitation, any amount disallowed can be carried over and deducted in later years.
- Taxes on land acquired and held for investment may avoid the $10,000 state and local tax limitation. A tenable position may be taken that these taxes are deductible on Schedule A under Section 2121 as a production-of-income2 activity.
The changes to the standard and itemized deductions under the TCJA bring renewed attention to the potential of a Section 266 election. The mechanics of the election are straightforward—it should be filed with an original return (even if late-filed)—and the results of the election are measurable. And if the underlying property is held by a pass-through entity, the election is made at the entity (not owner) level.
1 See Section 164(b)(6)(B)
2 Treasury Regulations Section 1.212-1(b)
Jeffrey J. Schrader, CPA, MST, is shareholder with Jeffrey J. Schrader, CPA, PC in Trenton, N.J. He can be reached at firstname.lastname@example.org.
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