Section 266 Election: Capitalize Carrying Charges on Real Property

The Section 266 election lets you skip the current deduction for property taxes, loan interest, and similar carrying charges and add those costs to the property’s basis instead. It’s worth making when the immediate deduction would be wasted — you’re in a loss year, sitting in a low bracket, already over the SALT cap, or exposed to AMT — because a higher basis reduces your taxable gain on sale or feeds depreciation later, at a full dollar-for-dollar rate.

You make the election by attaching a statement to a timely-filed original return. For construction, development, and installation projects, that choice binds you until the project ends. For vacant land held as an investment, you get to decide fresh each year.

What the Election Does

Normally, carrying charges like property taxes and mortgage interest reduce taxable income in the year paid. Section 266 lets you voluntarily opt out of that treatment and treat the amount as part of the property’s original cost or as a basis adjustment.¹²

The higher basis pays off later. When you sell, a bigger basis means a smaller taxable gain. If the property is depreciable, the capitalized costs feed into your depreciation or amortization deductions over the asset’s recovery period. Either way, the tax benefit shifts forward in time rather than disappearing.

One boundary matters up front. Only expenses that are “otherwise expressly deductible” under the tax code qualify. A cost that’s already nondeductible for some other reason — a penalty, a fine, an expense that fails another Code requirement — can’t be rescued by capitalizing it under Section 266.²

What Property and Costs Qualify

The Treasury Regulations split the election into three property categories, each with its own list of eligible charges and its own cutoff.

Unimproved and Unproductive Real Property

This covers raw land that isn’t producing rental income, business revenue, or any other economic return. Vacant land held as an investment or for future development is the classic case. Eligible carrying charges include annual property taxes, mortgage interest, and other carrying costs.²

The election here is annual. Capitalize property taxes this year and deduct them next year if you want. Nothing locks you in.

Real Property Under Development or Construction

This is the broadest category. It applies to any real property — improved or unimproved, productive or unproductive — where development or construction of an improvement is underway. Eligible costs include:

Interest on borrowed funds used for the project. Theoretical interest on your own money doesn’t qualify.
Employment taxes measured by compensation paid to employees working on the development or construction.
Taxes on the purchase, storage, or consumption of construction materials.
Other necessary expenditures tied to the construction, such as utilities and maintenance costs during the project.

All of these are eligible only through the date the development or construction is completed.² Once the project ends, ongoing expenses go back to being ordinary deductions unless a different category applies.

Personal Property in Transit or Being Installed

This covers machinery, equipment, and other fixed assets between acquisition and the moment they go into service. Eligible costs:

Employment taxes measured by compensation for employees who transport or install the equipment.
Interest on money borrowed to buy, transport, or install the property.
Taxes imposed on buying, storing, or consuming the property itself.

The cutoff is the later of when the property is physically installed or when you first put it to use.² Equipment sitting idle after installation keeps the window open until you actually start using it.

When Capitalizing Beats Deducting

Take the deduction most years. Immediate cash almost always beats deferred cash because of the time value of money. The election earns its keep only when the current-year deduction is worth less than face value, or worth nothing at all.

Loss Years and Low-Bracket Years

If you’re already showing a net operating loss, deducting more carrying charges just makes the loss bigger. NOL carryforwards are permanently capped at 80% of taxable income in a future year, so a larger loss doesn’t translate dollar-for-dollar into savings down the road. Capitalizing instead turns those charges into basis, which reduces gain at a 1:1 ratio when the property is sold or depreciated. No 80% haircut.

The SALT Deduction Cap

For 2026, the state and local tax deduction is capped at roughly $40,400 for most filers (the $40,000 base under the One Big Beautiful Bill Act increases 1% annually after 2025). For filers with modified adjusted gross income above $500,000, the cap phases down and can drop as low as $10,000. If your state and local taxes already exceed the cap, deducting more property taxes on the return produces zero benefit. The excess vanishes.

Capitalizing property taxes under Section 266 sidesteps the cap. The taxes aren’t claimed as an itemized deduction at all; they’re added to basis. The full amount reduces your taxable gain on sale regardless of the SALT limitation. For taxpayers holding land or managing construction projects in high-tax states, this is often the single largest reason to make the election.

AMT Exposure

Under the alternative minimum tax, state and local property taxes aren’t deductible at all. Capitalizing those taxes converts a completely disallowed AMT deduction into a basis adjustment that reduces gain under both the regular tax and the AMT. If AMT is a recurring issue, the election delivers a permanent benefit rather than a temporary preference item.

Anticipated Higher Future Rates

If you expect a significantly higher bracket in the year you sell or begin depreciating the property, deferring the benefit can produce a larger net saving. A deduction worth 22 cents today might be worth 35 cents in a future year. Do the arithmetic with the time value of money in mind. A deduction taken today and invested can still beat a bigger deduction years from now if the rate gap isn’t wide enough.

How to Make the Election

Attach a statement to your original federal income tax return for the year in question, filed by the due date including extensions. The statement identifies the property and lists the specific expense categories being capitalized.²

You can’t cherry-pick within a category on a single project. If you have property taxes across several parcels being developed together, the election has to cover all of them, not just the ones with the biggest bills.

How Long the Election Lasts

For unimproved and unproductive real property, the choice is annual. Capitalize this year, deduct next year, capitalize the year after that.

For development, construction, and installation projects, the election stays in place until the project is completed or the property is placed in service. It’s treated as a method of accounting, and changing it mid-project requires IRS consent through Form 3115 (Application for Change in Accounting Method), typically filed within 180 days after the start of the tax year in which you want to switch.

If you missed the deadline on your original return, relief isn’t automatic. Make the election on time or take the deduction.

How Section 263A and Section 163(j) Limit the Election

Section 263A (the uniform capitalization or UNICAP rules) already forces certain producers and resellers to capitalize direct and indirect costs, including interest, for property they produce or acquire for resale. Those mandatory rules apply before Section 266 enters the picture.² If UNICAP already requires capitalization, the Section 266 election is irrelevant for that cost.

Section 266 still matters for indirect costs that fall outside UNICAP’s reach. Interest on loans to acquire personal property that doesn’t meet the minimum production-period or cost thresholds for “designated property” under the Section 263A interest capitalization rules is one example. Property taxes on investment land, which typically isn’t “produced” property, is another.

For tax years beginning after December 31, 2025, the One Big Beautiful Bill Act changed the order of operations between Section 266 and the business interest expense limitation under Section 163(j). Through 2025, some taxpayers used Section 266 to capitalize interest and keep it out of the Section 163(j) calculation entirely: capitalized interest wasn’t a “deduction” that could be limited.

Starting in 2026, Section 163(j) applies first. Only interest that survives the business interest limitation is available to capitalize under Section 266. Interest disallowed under 163(j) stays disallowed. The same legislation permanently restored the more generous EBITDA-based calculation of adjusted taxable income under Section 163(j), so more interest passes through the 163(j) gate in the first place, but the old bypass around that gate is closed.

1
Office of the Law Revision Counsel. 26 USC 266 – Carrying Charges
2
eCFR. 26 CFR 1.266-1 – Taxes and Carrying Charges Chargeable to Capital Account