The Tax Navigator – Section 266 and Section 163(j): What Taxpayers Need to Know

Join Sean Muller, The Tax Navigator, and Greg Rivers as they explain how Section 266 works, including how capitalizing interest into inventory or accounts receivable can affect Section 163(j) interest limitations. They also discuss a time-sensitive opportunity available for the 2025 tax year before IRS ordering rules change in 2026.

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Detailed Description of The Tax Navigator – Section 266 and Section 163(j): What Taxpayers Need to Know

00:00:00
Sean: I’ve got Greg Rivers joining me today, and we’re going to talk about Section 266. While it wasn’t a new rule that was passed as part of the OBBBA, they did change the ordering around [Section] 163(j) interest related to 266. So, what is Section 266?

00:00:15
Greg: So, Section 266 has been around forever. And what it allows us to do, it’s a rule around carrying charges.

00:00:23
Greg: And it tells you that if you take out debt and go use that debt for a specific purpose, you are required to attribute some of those items, some of that interest expense, over to those items.

00:00:36
Sean: Okay. So, you go buy a piece of equipment. It’s similar to UNICAP rules. The interest expense attaches to that debt related to that purchase. So, you should be capitalizing that interest to the asset and the UNICAP context and 266 is there for that reason?

00:00:50
Greg: Absolutely.

00:00:51
Sean: Alright. So, when you look at 266 then, why did Congress feel they had to reorder 266 and the 163(j) rules?

00:01:04
Greg: So, what happened was so there’s a couple things that happened with 163(j). So, first thing they gave us, they were being nice. The first thing they did is they changed the calculation to be based on EBITDA. It was just based on EBIT. So, in ’25, actually less taxpayers are going be subject to 163(j) since they’re giving you the depreciation and amortization back.

00:01:25
Greg: But they did a second thing. So, starting in ’26, what they did is they changed the ordering rules because they didn’t like that taxpayers were avoiding 163(j) using Section 266. They found out that a lot of taxpayers were being savvy, and they were appropriately using Section 266 to avoid the limitations on a 163(j).

00:01:45
Sean: But how are they doing that? Because they were capitalizing the interest to other assets that were being recovered as they were sold?

00:01:52
Greg: Absolutely. Yes. So, the main things that people are using Section 266 for are inventory and accounts receivable. A lot of taxpayers have heard about this. And so, what they’re doing is they’re saying, okay, I can take that interest expense that’s limited by 163(j), and I’m going to recharacterize it using principles from Section 266.

And now it’s actually going to be treated as inventory. And then so instead of being limited, now it’s actually going to run through my COGS (cost of goods sold), and so it’s going to be a current year deduction.

00:02:22
Sean: Okay. And so, for 2025, we’re into the old rules. So, this 266 capitalization exercise can be used to hype up or increase your 163(j) allowed interest?

00:02:37
Greg: Yes.

00:02:38
Sean: That’s only for 2025, so we got to file a timely filed return. Can we file it on a return with extensions, or what do we need to do there?

00:02:45
Greg: Both. So, it does need to be on a timely filed, return. It cannot be on an amended return, but if you file early, you can — this question I get a lot — you can do a superseded return up to the extended due date.

00:02:58
Sean: Okay.

00:02:59
Greg: So, if you’re not seeing this until later on, and you’ve already filed, we can file a superseded and get that in there.

00:03:04
Sean: If we file the etc. All that jazz.

00:03:06
Greg: Yes.

00:03:07
Sean: Alright. Well, I appreciate it. So we have some time — we’ve got 10 or 11 months from now to get all this stuff done — but we have an advantage of 266. So, if we have 163(j) limits for 2025, we should consider it using 266, right?

00:03:18
Greg: Absolutely.

00:03:19
Sean: All right. Great, thank you.

This episode of The Tax Navigator was recorded prior to publication. Some references or updates discussed may reflect information current as of the recording date.