The election to capitalize carrying costs, authorized by Section 266 of the Internal Revenue Code, lets you add otherwise-deductible expenses like property taxes, loan interest, and maintenance to a property’s tax basis instead of writing them off in the year you pay them. You make the election by attaching a written statement to your original tax return for the year the costs are incurred, identifying the specific items you want to treat as chargeable to the capital account. There is no dedicated IRS form.
Why Give Up a Current Deduction
For most taxpayers in a profitable year, deducting carrying costs under Section 162 is the better move because it lowers taxable income immediately. The Section 266 election exists for the years when that immediate deduction has little or no value to you.
If your business is already running a loss, or you are sitting on substantial net operating loss carryforwards, another current deduction just piles onto losses you may not use for years. Capitalizing instead gives you two future benefits: larger depreciation deductions over the asset’s recovery period, and a smaller taxable gain when you sell. A taxpayer who expects to move into a higher bracket, or who holds appreciating land that will eventually be sold, can find the basis increase worth more dollar-for-dollar than the write-off would have been.
The decision is a planning exercise, not a routine filing choice. It requires modeling expected income over the holding period of the asset.
Which Property and Costs Qualify
The Treasury Regulations limit the election to three categories, and a cost must already be deductible under the tax code before you can elect to capitalize it. You cannot use Section 266 to capitalize something that would not have been deductible in the first place.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 common one. It covers land that is not generating meaningful income and is not under active development. While you hold the land in that state, you can elect to capitalize annual property taxes, mortgage interest, and other carrying charges such as the cost of protecting or maintaining the land. Once the land enters active development or you sell it, this category no longer applies.
Real Property Under Construction or Development
When you are building on or substantially improving real property, a second set of costs becomes eligible: interest on construction loans, employer taxes measured by compensation paid to construction workers, taxes on the purchase or storage of materials, and other necessary expenditures tied to the development work.2Internal Revenue Service, Treasury. 26 CFR 1.266-1 – Taxes and Carrying Charges Chargeable to Capital Account and Treated as Capital Items The eligible period 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 during the stretch between acquisition and the point when the asset is installed and ready for use. Eligible costs include employer taxes measured by wages of installation employees, taxes on the purchase or storage of the equipment, and interest on loans financing the acquisition and installation.
One constraint applies across all three categories. You can pick which types of costs to capitalize on a given project, but if you capitalize one type, you must capitalize every item of that type on that project. No cherry-picking which months of property taxes to capitalize and which to deduct on the same development. Different projects can get entirely different treatment in the same year.
How to File the Statement
You make the election by attaching a written statement to your original tax return for the year the costs are incurred. The regulation requires the statement to indicate which items you are electing to treat as chargeable to capital account and whether they relate to the same project or different projects.
A well-prepared statement identifies each property clearly (address for real estate, detailed description for equipment), lists each category of expense separately with its dollar amount, and cites Treasury Regulation Section 1.266-1 so the IRS knows exactly which election you are making. The statement goes on 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 return’s filing due date, including extensions. An election filed on an amended return after that date is generally invalid.
If You Miss the Deadline
If you fail to attach the statement to your original return, the IRS treats you as having chosen to deduct the carrying costs in the current year. There is no automatic second chance. Relief for late regulatory elections exists through the IRS’s administrative procedures, but obtaining it requires demonstrating reasonable cause and is not guaranteed. For unproductive land, where the decision recurs annually, evaluate the election well before the filing deadline each year.
How Long the Election Binds You
The duration depends on the category.
For unimproved and unproductive real property, the election is effective only for the tax year in which it is made. You decide again every year. Capitalize this year’s property taxes, deduct next year’s. That annual flexibility is one reason the election is most often associated with vacant land.
For construction and development projects, the election locks in from the start of the project through completion. For machinery and equipment installation, it locks in until the later of the installation date or the date the asset is first used. Once you elect to capitalize a type of cost on one of these projects, you must keep capitalizing that type for the project’s entire duration, even if the project spans multiple tax years. Switching mid-project requires IRS consent.
How You Recover the Capitalized Costs
Capitalized amounts are added to the property’s basis. How you recover that basis depends on the asset.
For depreciable property such as buildings or equipment, the added basis is recovered through depreciation deductions over the asset’s recovery period. Capitalized interest included in a depreciable asset’s basis is recovered the same way. You are effectively spreading the tax benefit of the carrying cost over many years instead of claiming it all at once.
For land, which is not depreciable, the increased basis produces no annual benefit while you hold the property. The entire benefit arrives at sale, where the higher basis reduces your taxable gain. A current-year deduction you could not have used becomes a reduction in capital gains tax years, sometimes decades, later.
That difference matters for planning. Capitalizing costs into a building depreciated over 27.5 or 39 years produces a slow trickle. Capitalizing costs into land produces nothing until sale. The right choice depends entirely on your timeline and income projections.
Where Section 263A Takes the Choice Away
Section 266 is optional. Section 263A is not. Knowing where the two meet keeps you from thinking you made a strategic choice about a cost you were already required to capitalize.
Under Section 263A, if you produce real property or certain tangible personal property, the IRS requires you to capitalize direct and allocable indirect costs, including interest, as part of the asset’s cost. All real property you produce is automatically treated as “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 at least one of these thresholds:
- The property has a depreciable class life of 20 years or more.
- The estimated production period exceeds two years.
- The estimated production period exceeds one year and estimated costs exceed $1,000,000.
Where 263A already requires capitalization, the Section 266 election has nothing to do. The 266 election matters for carrying charges that fall outside 263A’s reach, such as property taxes on unproductive land or interest on property that does not qualify as designated property.
There is a significant small-business exception. A taxpayer whose average annual gross receipts over the prior three years do not exceed $25 million (adjusted for inflation) is generally exempt from Section 263A’s mandatory capitalization rules entirely, provided the taxpayer is not a tax shelter. For these smaller taxpayers, costs that larger businesses must capitalize are deductible by default, which makes the Section 266 election a genuine choice.
Records You Have to Keep
Because capitalized carrying costs affect basis, you must keep the supporting records far longer than you would for an ordinary deduction. The IRS requires you to retain property-related records until the statute of limitations expires for the tax year in which you dispose of the property.4Internal Revenue Service. How Long Should I Keep Records? For most sales, that means three years after the return reporting the sale is filed.
In practice, that can mean holding records for decades. If you capitalize carrying costs into vacant land in 2026 and sell in 2045, you need the 2026 records available through at least 2048. Keep a copy of the election statement itself, the underlying invoices or tax bills, and any workpapers showing how you allocated costs among properties or projects. If the property was received in a nontaxable exchange, you must also retain the records from the original property.
Lose those records and you may be unable to substantiate the higher basis when you sell, forfeiting the benefit of every election you ever made on the property.