Individual taxpayers with investment property lost a potential tax deduction when the 2017 Tax Cuts and Jobs Act (TCJA) created a $10,000 cap on the deduction for state and local taxes paid. The individuals may want to consider a Section 266 election to capitalize those items and capture those lost deductions in the future.
Section 266 allows taxpayers to capitalize taxes, interest, and carrying charges that would otherwise be lost or limited under other provisions in the tax code. The election is made on a year-by-year basis and can be for any or all of those three categories of expenses.
For example, assume an individual owns raw land or other real property for investment (also assume that individual is not a real estate developer and has no other Schedule C/E/F activities where you could allocate those deductions). That individual incurs $10,000 of interest expense, $15,000 of real estate taxes, and $20,000 of other carrying costs.
The interest expense could qualify as investment interest expense, with the current deduction limited to investment income. The taxpayer could elect to tax long-term capital gains (if any) at ordinary rates to allow the interest deduction. Alternatively, a 266 election would allow the taxpayer to capitalize the interest expense and increase their basis in the property, which would reduce the gain upon an ultimate disposition.
Real Estate Taxes
The individual’s itemized deductions would likely already be subject to the $10,000 cap on state and local taxes due to income and other property taxes, so the real estate taxes on the investment property would be in excess of that cap and would generate no tax benefit. A 266 election would add these taxes to the basis in the property and reduce future gain on disposition.
These items would historically be considered miscellaneous itemized deductions subject to the 2% threshold, which typically generated little tax benefit due to income limitations and Alternative Minimum Tax. However, the TCJA of 2017 eliminated miscellaneous itemized deductions for the 2018 to 2025 tax years. To qualify for 266 treatment, the items must be “otherwise deductible” so these costs may not qualify. However, some commentators have argued the miscellaneous itemized deduction rules were merely “suspended” not repealed, so the eligibility of these costs is still being determined.
For clients incurring significant carrying costs on investment property, a 266 election may be an effective way to generate tax savings from items providing little or no current tax benefits. This can be especially useful for taxpayers with investment real estate in high property tax jurisdictions.