Sec. 266—The Best of Both Worlds

Sec. 266 allows a taxpayer to elect to capitalize interest and carrying charges, an election that is usually ignored. Sec. 263A requires a taxpayer to capitalize interest and carrying charges in most situations and, generally, a current deduction reducing ordinary income is worth more than an increase in basis, which at some future date will reduce long-term capital gain. When a taxpayer is holding real estate strictly as an investment, property taxes and interest are deductible currently, unless he makes an election under Regs. Sec. 1.266-1.

A taxpayer can elect to capitalize property taxes, reducing current-year tax and increasing the underlying property's basis. In computing alternative minimum tax (AMT), a taxpayer must add back taxes taken as an itemized deduction. Therefore, there is no benefit for taxes paid on investment property. If the ordinary portion of a taxpayer's tax liability is small and the AMT relatively large, electing to capitalize the property tax can reduce the total tax liability for the current year. Even if the current-year's tax liability is the same, electing to capitalize current-year carrying charges increases the basis of the property that may be sold in the future and will reduce the tax on sale.

In one example in the regulations, reducing itemized deductions by $10,000 saved $600 in current taxes. Further, it will reduce future capital gain tax by $2,000 at current rates.

The election is binding only for the current year. Depending on the taxpayer's facts and circumstances, he may elect to capitalize "any one or more of such items"; see Regs. Sec. 1.266-1.

From Vernon F. Peterson, CPA, Peterson & Associates, P.S., Vancouver, WA (Not associated with AFAi)