Vacant Land Owners Take Note: New Tax Law Accelerates Benefits of Obscure Tax Provision
Owners of “unimproved and unproductive real estate” probably already know that even if they took out a mortgage to purchase their lot, they can’t deduct the interest on it if they do not have a residence on the land or on a lot adjacent to it. Such interest, however, can be added to the “basis” (how much you paid for and invested in the land), resulting in less taxable profit when the lot is sold. The way to do that is to attach a statement to your return called an “election” under Section 266 of the Internal Revenue Code. The election statement usually runs like this “Taxpayer hereby elects under Section 266 to capitalize $ xxxx.xx of mortgage interest on x acres of unimproved and unproductive land at xxx Harmony Lane, Melody, TX for Tax Year 20xx.” Tax software frequently includes the capability to attach such statements to a return filed electronically. Making the election annually on your return could add up to real money saved once the lot is sold years later.
Carrying charges, such as property maintenance and property owner association fees, perhaps even liability insurance premiums, can also be capitalized. Property or homeowner association fees are not deductible as taxes because they are levied by private associations, rather than governmental entities. The S. 266 election allows you to get an eventual tax benefit from those fees even if you cannot deduct them immediately. All you have to do is add additional clauses to the above election statement, such as “ and $ xxx.xx in property association dues.”
Property taxes can be capitalized under S. 266 as well, but usually aren’t since all taxes can be deducted on Schedule A. The exception would be when a taxpayer’s itemized deductions do not add up to more than the standard deduction. If that is the case, then the property tax expense provides no tax benefit. It might as well be capitalized under S. 266 so it can decrease taxable profit upon the sale of the land. The S. 266 election cannot be made retroactively, however. It must be filed with the return by the due date, whether April 15 or, if an extension request has been filed, by October 15 (the specific due date may vary due to holidays).
The new tax law enacted by Congress makes the S. 266 election much more useful to owners of vacant land. Recall that standard deductions are roughly doubled, so that married couples, for example, will have a standard deduction of $ 24,000. At that deduction level, many, if not most, taxpayers will find that the standard deduction exceeds their itemized deductions. But that is precisely the situation made to order for taking the S. 266 election. You can get the benefit of the high standard deduction and still reduce tax on an eventual land sale.
Now you might think, “I am in only the 10 or 15 percent tax bracket and the long-term capital gains tax rate for persons in those brackets is zero so I don’t need to do this.” But what matters is not your tax bracket in the years you are making the S. 266 election. It is what your tax bracket is in the year you sell the property, since that is the year that capital gains tax, if any, will be owed (unless, of course, you sell on an installment basis, spreading out your income, and tax owed, over a number of years). You might end up in a higher bracket during the year you sell the property, in which case you will wish you had used the S. 266 election.
The main challenge is whether the owner is going to remember about his or her S. 266 elections when the land is sold. To be sure to claim it, the taxpayer should save a copy of the S. 266 election page from the return for each year it is claimed and place it in a file that includes the original settlement statement, as well as records of and receipts for all improvements to the property. That way the entire package will be ready for a tax professional to calculate the capital gain on the property sale after it occurs. Section 266 is a specialized code provision–you will not find anything about it in a popular guide like J.K. Lasser’s Your Income Tax, although there are plenty of articles about it on the internet. If you own a vacant lot that you are not using as agricultural or commercial property and have questions about when and how to use the S. 266 election, consult a qualified tax professional.
Prepared by Edward J. Michal, Enrolled Agent and owner of Delta Tax Service, Dripping Springs, TX.