The election to capitalize carrying costs, made under Section 266 of the Internal Revenue Code, lets you add otherwise-deductible expenses like property taxes, loan interest, and maintenance charges to a property’s tax basis instead of deducting them in the year you pay them. You make the election by attaching a written statement to your original, timely-filed return for the year the costs are incurred, identifying the property and the specific items you want to treat as capital. It is genuinely optional, and for most taxpayers in most years a current deduction is worth more. The election earns its keep in the narrower situations where that current deduction would go to waste.
When Capitalizing Beats Deducting
An immediate deduction under Section 162 usually wins. It reduces this year’s taxable income at this year’s marginal rate. The reason Section 266 exists is that “this year’s marginal rate” is sometimes zero, or close to it.
If your business is already running a loss, or you’re sitting on net operating loss carryforwards you can’t absorb, another deduction just deepens a pile you may not use for years. Rolling those costs into basis converts a currently useless deduction into two future benefits: larger depreciation deductions over the asset’s recovery period, and a smaller taxable gain when you sell.
The decision comes down to modeling income across the holding period. A taxpayer heading into higher brackets, or holding land that is appreciating steadily with no offsetting income, can find each dollar of basis worth more than each dollar of current deduction. That’s why the election shows up most often in vacant-land holdings and long-horizon development plans rather than routine operating businesses.
What Property and Costs Qualify
The regulation limits the election to three categories of property, and within each category to specified carrying charges. A cost must be otherwise deductible before it can be capitalized under Section 266. You cannot use the election to rescue an expense that wasn’t deductible to begin with.1eCFR. 26 CFR 1.266-1 – Taxes and Carrying Charges Chargeable to Capital Account and Treated as Capital Items
Unimproved and Unproductive Real Property
This is the most common use of the election. It applies to land that isn’t generating meaningful income and isn’t under active development. Eligible charges include annual property taxes, mortgage interest, and other costs of protecting or maintaining the land while you hold it.
Real Property Under Construction or Development
Once you’re building on or substantially improving real property, a different set of costs becomes eligible: interest on construction loans, employer taxes on construction wages, taxes on the purchase or storage of materials, and other necessary expenditures tied to the development.2Internal Revenue Service, Treasury. 26 CFR 1.266-1 – Taxes and Carrying Charges Chargeable to Capital Account and Treated as Capital Items The eligible window runs from the start of construction until the property is completed and ready to be placed in service or held for sale.
Machinery and Equipment Being Installed
The third category covers tangible personal property between acquisition and the point it is installed and ready for use. Eligible costs include employer taxes on installation wages, taxes on the purchase or storage of the equipment, and interest on loans financing the acquisition and installation.2Internal Revenue Service, Treasury. 26 CFR 1.266-1 – Taxes and Carrying Charges Chargeable to Capital Account and Treated as Capital Items It runs until the later of the installation date or the date the equipment is first put into use.
One constraint applies across all three categories. You can pick which types of costs to capitalize on a given project — taxes but not interest, say — but once you capitalize a type of cost, you must capitalize all items of that same type on that project. You cannot split months of property taxes on the same development between capitalization and deduction.1eCFR. 26 CFR 1.266-1 – Taxes and Carrying Charges Chargeable to Capital Account and Treated as Capital Items Across separate projects, your elections can differ.
What Section 266 Doesn’t Cover: The 263A Boundary
Section 266 is an optional election. Section 263A is a mandate. If you produce real property or certain tangible personal property, 263A already forces you to capitalize direct and allocable indirect costs, including interest, into the asset’s cost. All real property you produce is automatically “designated property” subject to mandatory interest capitalization under Section 263A(f).3Internal Revenue Service. Interest Capitalization for Self-Constructed Assets
Tangible personal property triggers mandatory interest capitalization under 263A only if it meets one of these thresholds:
- Depreciable class life of 20 years or more.
- Estimated production period exceeds two years.
- Estimated production period exceeds one year and estimated costs exceed $1,000,000.
Where 263A already applies, a Section 266 election adds nothing. The election matters for carrying charges that fall outside 263A’s reach, such as property taxes on unproductive land or interest on property that isn’t designated property. There’s also a meaningful carve-out for small businesses: a taxpayer whose average annual gross receipts over the prior three years don’t exceed $25 million (indexed for inflation) is generally exempt from 263A entirely, as long as it isn’t a tax shelter.3Internal Revenue Service. Interest Capitalization for Self-Constructed Assets For those taxpayers the Section 266 election is a real choice, because costs larger businesses must capitalize by law are deductible for them by default.
How to File the Election
There is no IRS form for this. You make the election by attaching a written statement to your original return for the year the costs were incurred. The regulation requires the statement to identify which items you’re treating as chargeable to capital account and whether they relate to the same project or to different projects.1eCFR. 26 CFR 1.266-1 – Taxes and Carrying Charges Chargeable to Capital Account and Treated as Capital Items
A workable statement includes a clear description of each property (address for real estate, detailed description for equipment), each category of expense listed separately with its dollar amount, and a citation to Treasury Regulation Section 1.266-1 so the IRS knows exactly what election you are making. Attach it to whichever return reports the property’s activity — Form 1040 for individuals, Form 1120 for C corporations, Form 1065 for partnerships.
The deadline is the original filing due date of that return, including extensions. An election filed on an amended return after the original deadline has passed is generally invalid. If you miss it, the IRS treats you as having chosen to deduct the carrying costs currently. Relief for late regulatory elections exists through IRS administrative procedures, but it requires showing reasonable cause and is not guaranteed. For unproductive land, where the decision recurs annually, evaluate it well before the filing deadline every year.
How Long the Election Binds You
Duration depends on the category. For unimproved and unproductive real property, the election applies only to the tax year in which it is made.1eCFR. 26 CFR 1.266-1 – Taxes and Carrying Charges Chargeable to Capital Account and Treated as Capital Items Capitalize this year, deduct next year, capitalize again the year after. That annual flexibility is why vacant land is the classic use case.
For construction and development projects, the election locks in from the start of the project through completion. For machinery and equipment, it locks in until the later of installation or first use.2Internal Revenue Service, Treasury. 26 CFR 1.266-1 – Taxes and Carrying Charges Chargeable to Capital Account and Treated as Capital Items Once you elect to capitalize a type of cost on a project, you must keep capitalizing it for the project’s entire duration, even across multiple tax years. Switching to deduction mid-project requires IRS consent.
How You Get the Money Back
Capitalized carrying charges are added to the property’s basis. Recovery depends on what kind of asset holds that basis.
For depreciable property like buildings or equipment, the added basis is recovered through depreciation deductions over the asset’s recovery period. Capitalized interest inside a depreciable asset is recovered the same way. You are trading an immediate deduction for a slow trickle spread across the recovery period — 27.5 or 39 years for most buildings.
For land, which is not depreciable, the added basis produces no annual benefit at all. The entire payoff arrives at sale, where the higher basis reduces taxable gain. A carrying cost that would have been a wasted deduction in a loss year can become a real reduction in capital gains tax decades later. The right answer depends on your holding period and income trajectory, not on any general rule of thumb.
Records You Have to Keep
Because capitalized costs affect basis, the supporting records have to survive much longer than records for ordinary deductions. The IRS requires you to keep property records until the period of limitations expires for the year you dispose of the property.4Internal Revenue Service. How Long Should I Keep Records? For most sales that’s three years after the return reporting the sale is filed.
In practice this can mean holding records for decades. Capitalize carrying costs on vacant land in 2026, sell in 2045, and you need the 2026 records available through at least 2048. Keep the election statement itself, the underlying invoices and tax bills, and any workpapers showing how you allocated costs among properties or projects. If the property was received in a nontaxable exchange, retain the records from the original property as well.4Internal Revenue Service. How Long Should I Keep Records? Without documentation, you may be unable to substantiate the higher basis at sale, which wastes the entire benefit of the election you made years earlier.