Category: Real Estate, Accounting Periods & Methods
Subject: Carrying Costs, Unproductive Property
Title: Capitalization vs. Deduction of Expenses
IRC Sections: 266
Filename: 1106.html
Date Produced: 3/97

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Background
Taxpayer is a limited partnership holding unimproved land for investment. The property produces no income. Taxpayer has paid property taxes, accounting fees, and the $800 California minimum tax applicable to limited partnerships.

Issues
1. What, if any, of these expenses can be capitalized under Section 266?

2. Can the taxpayer elect to capitalize expenses with respect to some types of items while deducting other types?

Discussion
Reg §1.266-1(b)(1)(i) provides that a taxpayer which owns unimproved and unproductive real estate can elect to capitalize annual taxes, interest on a mortgage, and other carrying charges. The election must be made annually. The election requires a statement in the taxpayer's return setting forth the description of the property and the expenses to which the election applies. In addition, if the property produces income in a given year, the election is not available.

It is clear that property taxes can be the subject of an election under Section 266. Reg. Section 1.266-1(d), Example 1.

The phrase "annual taxes" is not defined in the regulation or elsewhere as far as I can determine. Given that the California minimum tax is imposed annually, I suppose it is at least arguable that the tax qualifies for the election. At minimum, I can find nothing that specifically prohibits an election with respect to such items. I think the IRS would likely take the position that capitalizable expenses under Section 266 must bear a proximate relationship to the property itself. In this case, the expense in question relates not to the property but to the entity that holds the property. Frankly, there is no clear answer to this question. On balance, I would not advise a client to attempt to capitalize this item without advising them that there is a significant amount of risk associated with the election.

I believe that accounting fees for the limited partnership cannot be capitalized under Section 266. Revenue Ruling 71-475, 1971-2 CB 304, provides that advertising, maintenance, and upkeep costs related to unimproved, unproductive property cannot be capitalized under Section 266. I think accounting fees in the instance are even less closely connected with the property than the expenses that are the subject of Revenue Ruling 71-475.

Finally, there is the issue of whether the taxpayer can capitalize some costs and deduct others. The regulations at Section 1.266-1(c)(1) provide that the taxpayer may elect to capitalize some of the categories of expenses enumerated in the regulations while deducting others. However, all items of the same category must either be deducted or capitalized. For example, the taxpayer could expense property taxes for a particular property while electing to capitalize mortgage interest on the same property; however, it would not be permissible to elect to capitalize some mortgage interest for a property while deducting other mortgage interest on the same property.