Do you own any vacant land for investment? If so, you have costs associated with that land, such as loan interest, real estate taxes, and “carrying charges” including mowing, insurance, HOA fees, and maintenance. The IRS allows you to make an annual election under Code Section 266 to “capitalize” these costs rather than deducting them each year.
A section 266 election is a statement you file with your income tax return stating something like this:
“For tax year 2016, taxpayer hereby elects under Code Section 266 and IRS Regulations 1.266-1 to capitalize, rather than deduct, property taxes, mortgage interest, insurance expenses, and other miscellaneous carrying costs on the 1234 10th Street vacant lot."
In other words, rather than deducting interest, real estate taxes, and carrying charges on the land, you are “electing” to add those expenses to the cost of the property. When you sell the property, you will have a lower capital gain (or higher loss) to report.
So why would you want to forego a tax deduction? I’ve got some good reasons:
· Carrying charges on land are deductible only if they exceed 2% of your AGI (Adjusted Gross Income), so most doctors will lose that deduction.
· Real estate taxes are an AMT (Alternative Minimum Tax) preference item and, therefore, probably not helpful as an itemized deduction for doctors.
· Investment interest expense is only deductible if offset by investment income.
· If you don’t need to itemize and can use the standard deduction, 100% of your investment property expenses can be capitalized and not wasted. This recently occurred with dual doctor clients who live in Florida (no state income taxes) and are renting a home. The 266 election will reduce their taxes when they sell their investment land.
You must annually elect to capitalize these expenses when you file your income tax return. You can elect to capitalize some categories and not others, but you cannot split categories. In other words, you can elect to capitalize real estate taxes but not mortgage interest, but you cannot capitalize part of your mortgage interest and deduct the rest. Finally, the election is available only for years that you have no income from the property.
If you have missed this election in prior years, you are probably out of luck. A Private Letter Ruling (“PLR”), asking the IRS to make a special determination just for your case, is your only way to know for sure, but it will cost you $4,200. (For example, in PLR 200629024 (2006), taxpayers were
granted permission to do this, but they had only 30 days from the PLR date to amend.) If the election could save you thousands of future tax dollars, a PLR might be beneficial if you are prepared to pony up $4,200.
As you can see, tax planning is not just for the current year but to minimize taxes over a lifetime. Having a long-time relationship with a CPA who is familiar with tax issues specific to doctors and other high-income professionals can ensure you clarify and follow a real plan for tax reduction.