To make a Section 266 election, attach a signed statement to your original federal income tax return for the year the charges were incurred, identifying the property, the category it falls under, the specific carrying charges you want to capitalize, and the dollar amounts.1Office of the Law Revision Counsel. 26 USC 266 – Carrying Charges The election moves those costs into the property’s basis instead of deducting them currently, which is worth doing when you can’t use the current deduction anyway, whether because of low income, passive activity limits, or a SALT cap that already absorbs your property taxes.
What the Election Statement Must Contain
Treasury Regulation 1.266-1 requires the statement to identify the specific items you’re electing to capitalize.2GovInfo. 26 CFR 1.266-1 – Taxes and Carrying Charges Chargeable to Capital Account and Treated as Capital Items A statement that will hold up under review typically includes:
- A reference to Treasury Regulation 1.266-1 as the authority for the election
- A description of the property (street address, legal description, or other identifying information)
- The category the property falls into: unimproved and unproductive, under development or construction, or machinery and equipment being installed
- Each type of charge being capitalized (interest, property taxes, employer payroll taxes, and so on)
- The dollar amount for each capitalized item
Keep the underlying documentation with your tax records: loan statements, property tax bills, payroll records, and vendor invoices. If the IRS questions the amounts or the election, you carry the burden of proof, and these are the records that will later substantiate your increased basis at sale or on depreciation schedules.
Which Return, and When
The election must be made on the original return for the year the charges were incurred, not on an amended return. Filing by the extended due date counts as timely, but filing late does not. The statement goes with Form 1040 for individuals, Form 1065 for partnerships, Form 1120 for C corporations, or Form 1120-S for S corporations. For partnerships and S corporations, the election is generally made at the entity level, and the capitalized amounts flow through as part of the owners’ basis in the entity’s property.
Pick the Right Property Category First
Treasury Regulation 1.266-1 splits the election into three property categories, each with its own list of eligible charges and its own rules about how long the election binds you.3eCFR. 26 CFR 1.266-1 – Taxes and Carrying Charges Chargeable to Capital Account and Treated as Capital Items Naming the wrong category on your statement can invalidate the election or lock you in longer than you expected, so settle this before you draft.
Unimproved and Unproductive Real Property
Vacant land or other real property producing no income. You can capitalize annual property taxes, mortgage interest, and maintenance costs like brush clearing or insurance. The election here is annual: capitalize one year, deduct the next, whichever fits your income situation. That flexibility ends the moment the property becomes productive.
Real Property Under Development or Construction
Once development or construction begins, eligible charges include loan interest, employer payroll taxes on construction workers, sales and use taxes on materials, and other necessary development costs incurred before the work is complete. The binding rule is different in this category: once you elect to capitalize a particular type of charge, you must continue to capitalize that same type of charge for the entire construction period. The election ends automatically when the work is finished. You can still be selective about which types of charges you elect on. Capitalizing interest doesn’t force you to capitalize property taxes.
Machinery and Equipment Being Installed
For personal property, the capitalization window runs from the date the asset is shipped or transported to your site until it is installed and ready for use, or first put into use, whichever is later. Inside that window you can capitalize employer payroll taxes on transport and installation workers, interest on loans used to acquire or move the equipment, and sales or use taxes on the property. Track the operational-readiness date carefully. Capitalizing past it overstates basis.
What Actually Qualifies as a Carrying Charge
A carrying charge is an expense to hold, maintain, or develop property that isn’t yet producing income, and the threshold requirement is that the expense must be otherwise deductible in the current year. If another Code section already requires capitalization, Section 266 has nothing to add. The uniform capitalization rules of Section 263A, for example, take precedence.
The qualifying charges you’ll most often see:
- Interest on debt used to acquire, carry, or develop the property, including mortgage interest on vacant land and construction loan interest. You cannot capitalize theoretical interest on your own funds. If you self-finance with cash, there is no interest to capitalize.3eCFR. 26 CFR 1.266-1 – Taxes and Carrying Charges Chargeable to Capital Account and Treated as Capital Items
- Real and personal property taxes that would otherwise be deductible under Section 164.4eCFR. 26 CFR 1.164-1 – Deduction for Taxes
- Employer Social Security and Medicare taxes on wages for workers developing or installing the property.
- Other necessary expenses directly tied to preserving or developing the property, such as maintenance, insurance, and security, provided they would be deductible as ordinary business expenses.5Office of the Law Revision Counsel. 26 USC 162 – Trade or Business Expenses
General overhead not tied to a specific property doesn’t qualify. There must be a clear link between the expense and the particular asset named in your election statement.
The election works on a charge-by-charge and property-by-property basis. You can capitalize interest while deducting property taxes on the same parcel, or capitalize on one project while deducting on another. Just remember the binding rule inside the development and machinery categories: once you elect on a type of charge, you’re committed to that type of charge for the duration of the project.
If You Already Missed the Filing Deadline
Because the election has to ride with the original return, it’s easy to lose. A missed deadline isn’t always fatal, but the fix is not automatic. Section 266 does not qualify for the 12-month automatic extension under Section 301.9100-2.6eCFR. 26 CFR 301.9100-2 – Automatic Extensions You have to seek discretionary relief under Section 301.9100-3, which means requesting a private letter ruling.
The IRS will grant the extension if you show two things: that you acted reasonably and in good faith, and that granting relief will not prejudice the government’s interests.7GovInfo. 26 CFR 301.9100-3 – Other Extensions Good faith is generally presumed if you request relief before the IRS discovers the omission, or if you relied on a qualified tax professional who failed to advise you about the election. The IRS is far less sympathetic where you knew about the election and passed on it, or where you’re now asking only because hindsight has made it advantageous. Prejudice to the government is found where granting the election would produce a lower total tax across affected years than a timely election would have, and relief is generally unavailable once the statute of limitations has closed on the election year. Private letter ruling requests carry user fees and require supporting affidavits, so weigh the cost against the benefit before filing.
Check These Limits Before You Elect
Three rules can reduce or eliminate the benefit of capitalizing, so run them before you commit.
Section 163(j) Runs First on Interest
For tax years beginning after December 31, 2025, the Section 163(j) business interest limitation applies before any elective interest capitalization under Section 266. The only exceptions are for interest capitalized under Sections 263(g) and 263A(f).8Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense Total business interest runs through the 163(j) calculation first. Interest disallowed there becomes a 163(j) carryforward and cannot be rerouted into basis through Section 266. Only interest that survives the filter is eligible for capitalization. Real property trades or businesses that have elected out of 163(j) under Section 163(j)(7) don’t face this ordering problem, because 163(j) doesn’t limit their interest to begin with.
Capitalized Property Taxes Don’t Add to AMT Basis
Capitalizing property taxes under Section 266 raises your regular-tax basis but not your alternative minimum tax basis. State and local real property taxes are not deductible in computing alternative minimum taxable income under Section 56(b)(1)(A), and the IRS has taken the position that taxes which are not deductible for AMT purposes cannot be added to AMT basis through a Section 266 election.9Internal Revenue Service. Private Letter Ruling PLR-116986-15 That creates a basis mismatch, and if you’re in AMT the year you sell, your AMT gain will be higher than your regular gain by the amount of property taxes you capitalized. Capitalized interest doesn’t cause the same issue because interest deductions are generally allowed for AMT.
The SALT Cap Can Make the Election Free
For 2025 through 2029, individual filers face a cap on total state and local tax deductions. For 2026, the cap is approximately $40,000 for most filers. If your other state and local taxes already push you to the ceiling, property taxes on an investment property produce no additional current deduction. In that case, capitalizing them under Section 266 costs nothing in lost current benefit and still raises your basis at sale. For investors in high-tax states who routinely exceed the cap, property taxes on unproductive real estate are usually an easy candidate for the election. Rerun the math each year, since your income, the cap, and your AMT posture can all shift the answer.