Section 266, Construction of Principal Residence

I'd like to confirm my understanding of how capitalization and section 266 works in the case of the construction of a principal residence:

1. Because section 263A doesn't apply to items constructed for personal use, taxpayers are generally limited to capitalizing only the direct costs that they pay for a principal residence, i.e. labor and materials.
   
2. However, until a construction project is completed, the land a taxpayer owns will be considered unimproved and unproductive real property, and any otherwise deductible costs of carrying the land could be capitalized into the basis of the land during this period under Reg. § 1.266-1(b)(1)(i). This would be real estate taxes and potentially mortgage interest if the loan is secured by the land and any property to be constructed on the land.
   
3. Further, the taxpayer can capitalize interest related to amounts spent to build the home into the basis of the home under Reg. § 1.266-1(b)(1)(ii). Again, the loan would need to be secured by the house. Additional real estate taxes attributable to the improvements on the property would not appear to be eligible for capitalization because they arise from the completed improvements and are not incurred in the process of making those improvements.
   
4. Because the interest and taxes must be "otherwise expressly deductible" under Subtitle A, they still count towards the $750k of indebtedness and $10k of taxes limitations imposed by the TCJA. Also, under 1.163-10T(p)(5)(i), only up to 24 months' worth of interest can be capitalized while the residence is under construction. However, under section 63(e)(1), the taxes and interest may still be capitalized even if the taxpayer elects to claim the standard deduction.
   
5. Finally, I believe that we would draw the line between what can be capitalized and what cannot by allocating taxes and interest paid to the periods to which they relate. For example, if construction finishes on February 1, and taxes covering the first six months of the year are paid on March 1, then one sixth of the taxes paid would be allocable to the period when the land was still "unimproved and unproductive", and therefore eligible for capitalization into the basis of the land.

How does all of that sound?

Is the goal to capitalize items that would otherwise be deducted as paid or incurred?

With a principal residence, the goal would be to take the standard deduction but also get some benefit out of the interest and taxes that would otherwise be deductible if the taxpayer itemized deductions.

Oh, I see now. But does that work?

At first blush, it does. Reg. 1.266-1(b)(2) says

(2) The sole effect of section 266 is to permit the items enumerated in subparagraph (1) of this paragraph to be chargeable to capital account notwithstanding that such items are otherwise expressly deductible under the provisions of Subtitle A of the Code. An item not otherwise deductible may not be capitalized under section 266.

. After all, the interest and taxes to which you refer are expressly deductible under sections 163 and 164.

But then we see section 63(b), which tells us to calculate taxable income, for those who don't itemize, by using the standard deduction. Here's the exact language.

(b) Individuals who do not itemize their deductionsIn the case of an individual who does not elect to itemize his deductions for the taxable year, for purposes of this subtitle, the term “taxable income” means adjusted gross income, minus—
(1) the standard deduction,
(2) the deduction for personal exemptions provided in section 151, and
(3) any deduction provided in section 199A.

.

So one way to interpret all this is that, by claiming the standard deduction, the items you'd like to capitalize can't be, because not only are they not expressly deductible; they are expressly not deductible.

See point #4 in my first post. Section 63(e)(1) provides that the deductions are in fact allowable:

Unless an individual makes an election under this subsection for the taxable year, no itemized deduction shall be allowed for the taxable year. For purposes of this subtitle, the determination of whether a deduction is allowable under this chapter shall be made without regard to the preceding sentence.

I overlooked that. Interesting.

OK, tongue in cheek, but maybe not so much. That 63(e)(1) needs closer perusal and analysis. Its first sentence is very clear. I can elect to itemize, or I am stuck with a standard deduction. Old news, a decision we all make for all returns every year.

But that second sentence is pretty darn broad. I can easily read it to nullify the first sentence, which, after all, is a part of "this chapter". Maybe they meant to say (but didn't): " For purposes of this subtitle other than the immediately preceding sentence, the determination of whether a deduction is allowable under this chapter shall be made without regard to the preceding sentence."

I hereby request that either Harry Boscoe or, even better, his pal Spell Czech, plus any and all other TPT experts, help us out here.

Well, my take on it is that the statute is deliberately creating a situation where the deductions "allowed" are less than the deductions "allowable". This type of situation usually happens because a taxpayer omits a deduction for one reason or another, but in this case it arises even when the letter of the law is strictly adhered to.

In most cases, what is "allowable" is determined by looking at deductions the taxpayer could have claimed regardless of whether or not those deductions actually made it to the tax return. Thus, "shall be allowed" = allowable, "shall not be allowed" = not allowable. But it doesn't flow in the other direction: what is allowable never determines what is actually allowed. Thus, changing how we look at "allowable" deductions cannot affect what deductions "shall" or "shall not" be allowed, and the second sentence in section 63(e)(1) cannot affect the first sentence.

Man, that's deep. I see it like this.

Per the first sentence of 63(e)(1), the only way you are "allowed" an itemized deduction is to elect it under "this subsection", which is 63(e). But electing it is just a first step; i.e., electing it does not by itself create the deduction - it has to meet other tests, the most obvious of which is actually paying it, and the next is meeting whatever tests apply to it. Those tests vary by section and regulation. But in no event is an itemized deduction "allowed" without the election.

But the second sentence of 63(e) tells us, for purposes of Subtitle A, which is called "Income Taxes" and has six chapters and covers sections 1 through 1564, to disregard the first sentence in determining whether a deduction is "allowable" under Chapter 1 (of Subtitle A), which is called "Normal Taxes and Surtaxes" and covers sections 1 through 1400Z-2.

But all we want to find out is whether the carrying charges in the OP meet the tests of reg. 1.266-1(b)(2), which is prescribed by section 266, which of course is part of both Subtitle A and its Chapter 1. That reg. never uses "allowed" or "allowable" in its text, but I have no problem equating what it does use, "expressly deductible" and "not otherwise deductible"), with "allowable" and "not otherwise allowable". So we make the section 63(e)(1) (second sentence) determination of whether those carrying charges are allowable without regard to the first-sentence rule, which has to do with an itemized deduction that's allowed.

Now, where was I?

At first glance, I would say that the income tax rules offer us a better take on "allowed" and "allowable" in the context of depreciation "allowed or allowable" but the folks who wrote those rules did so in the relatively simple, often-encountered, and quite obvious context of taxing the "recovery" of depreciation deductions availed of, not this relatively arcane context of "will I be allowed able to increase the tax carrying cost of my personal home by adding some financing costs incurred and paid but for which a tax deduction is subject to a maze of self-referential and sometimes self-canceling definitions."

If they had thought about it more carefully they woulda wrote it different.