Construction Industry ATG - Chapter 7 Homebuilders and Developers
Publication Date - May 2009
NOTE: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.
- Home Construction Contract Defined
- Taxation of Homebuilders
- Homes Built for Speculation (No Contract)
- Inventory vs. Real Estate
- Contractors Building Home Under Contract
- Land Developer
- Allocating Costs to Each Parcel of Property
Home construction contracts are one of the two exceptions from some of the requirements of IRC Section 460. The small contractor’s exception is the other one that is discussed in earlier chapter. Contracts that meet the home construction contracts definition are exempt from the following:
- The requirement to use percentage of completion method;
- The application of the look-back provisions; and
- The requirement to use percentage of completion method for alternative minimum tax purposes.
Even though exempt from the above requirements, construction period interest is still required to be capitalized under IRC Section 460(c)(3).
IRC Section 460(e)(1)(A) exempts any home construction contract and thus is not based on neither the length of the contract nor the gross receipts of the contractor as with the small contractors exception. However, the last sentence of IRC Section 460(e)(1) provides that home construction contracts that do not meet the 2-year or $10,000,000 gross receipts test are subject to the application of IRC Section 263A. These contractors are commonly termed Large Home Builders and are discussed separately.
IRC Section 460(e) provides an exception for certain construction contacts. In general, subs (a), (b), and (c)(1) and (2) shall not apply to:
- Any home construction contract, or
- Any other construction contract entered into by a taxpayer:
- Who estimates (at the time such contract is entered into) that such contract will be completed within the 2-year period beginning on the contract commencement date of such contract, and
- Who averages annual gross receipts for the 3 taxable years preceding the taxable year in which such contract is entered into do not exceed $10,000,000.
In the case of a home construction contract with respect to which the requirements of clauses (i) and (ii) of subparagraph (B) are not met, 263A shall apply notwithstanding subparagraph (c)(4).
Land developers are discussed later in this chapter because they are closely related to the home construction industry. The land developer may also construct the homes or only sell the improved lots to the homebuilders.
Home Construction Contract Defined
A home construction contract is any contract where 80% or more of the estimated total contract costs, as of the close of the tax year that the contract was entered into, is reasonably expected to be attributable to the building, construction, reconstruction, or rehabilitation of dwelling units contained in buildings containing four or fewer dwelling units and improvements to real property that are directly related to such dwelling unit. The distinction between a home construction contract and a residential construction contract is important because residential construction contracts do not meet the exception to the use of percentage of completion and look-back provided by IRC Section 460(e). Residential construction contracts contain more than 4 dwelling units (e.g. apartments, condominiums). Residential construction contracts are discussed in more detail in an earlier chapter.
IRC Section 460(e)(6)(A) provides that the term “home construction contract” means any construction contract if 80 percent of the estimated total contract costs (as of the close of the taxable year in which the contract was entered into) are reasonably expected to be attributable to activities referred to in paragraph (4) with respect to:
- Dwelling units as defined in IRC Section 168(e)(2)(A)(ii)) contained in buildings containing 4 or fewer dwelling units as so defined. For this purpose, each townhouse or rowhouse shall be treated as a separate building, and
- Improvements to real property directly related to such dwelling units and located on the site of such dwelling units.
Treasury Regulation 1.460-3(b)(2) provides that a contract of a subcontractor working for a general contractor is included in the definition of home construction contracts if it otherwise qualifies, and that common improvements that benefit the dwelling units being constructed or located at the site of the dwelling units are included as part of the 80% test.
Treasury Regulation 1.460-3(b)(2) provides that a long-term construction contract is a home construction contract if a taxpayer (including a subcontractor working for a general contractor) reasonably expects to attribute 80 percent or more of the estimated total allocable contract costs (including the cost of land, materials, and services), determined as of the close of the contracting year, to the construction of:
- Dwelling units, as defined in IRC 168(e)(2)(A)(ii)(I), contained in buildings containing 4 or fewer dwelling units (including buildings with 4 or fewer dwelling units that also have commercial units); and
- Improvements to real property directly related to, and located at the site of, the dwelling units.
Townhouses and Rowhouses
Each townhouse or rowhouse is a separate building.
A taxpayer includes in the cost of the dwelling units their allocable share of the cost that the taxpayer reasonably expects to incur for any common improvements (e.g., sewers, roads, clubhouses) that benefit the dwelling units and that the taxpayer is contractually obligated, or required by law, to construct within the tract or tracts of land that contain the dwelling units.
Mixed Use Costs
If a contract involves the construction of both commercial units and dwelling units within the same building, a taxpayer must allocate the costs among the commercial units and dwelling units using a reasonable method or combination of reasonable methods, such as specific identification, square footage, or fair market value.
Dwelling units are defined in IRC Section 168(e)(2)(A)(ii)(I). The term dwelling unit means a house or apartment used to provide living accommodations in a building or structure, but does not include a unit in a hotel, motel, or other establishment more than one-half of the units in which are used on a transient basis.
Mixed Use Buildings
If a contract requires construction of a mixed-use building (e.g. a building that will include both dwelling units and offices) the costs are allocated among the commercial units and the dwelling units using a reasonable method, pursuant to Treasury Regulation 1.460-3(b)(2)(iv).
Proposed Regulations Expand Definition of Home Construction Contract
On August 1, 2008 the Treasury and IRS released proposed regulations that expand the definition of a home construction contract. Prior to this date, the IRS and the industry were at odds as to whether a land developer providing common improvements without also constructing a home and subcontractors providing common improvements within a residential area were considered a home construction contract. The proposed regulations expanded the home construction definition to include these construction contracts. Additionally, the proposed regulations expanded the home construction definition to condominium developments that contain more than 4 dwelling units in a building. The condominiums are considered the same as rowhouse or townhouse in which each condominium unit is considered a single building. The proposed regulations also provide guidance to taxpayers electing to change their long-term method of accounting, providing which changes are accounted for under the cut-off method and which changes are accounted for using an IRC Section 481(a) adjustment.
At the time of the writing this chapter, these proposed regulations have not yet been finalized, and any user of this guide should research this area for the issuance of subsequent guidance.
Taxation of Homebuilders
To avoid confusion in the tax accounting rules, for both income and expenses, the following types of construction or development will be discussed separately:
- Homes Built for Speculation without a Contract
- Contractors Building Homes with a Contract
- Land Developers
Homes Built for Speculation (No Contract)
Homebuilders will purchase a number of lots from a developer of a subdivision to build houses. The homebuilder may build some of the homes as speculative (spec) homes. Speculative homes are not built under a contract. In the industry, homes built for speculation that are on hand at year end are referred to as inventory of unsold houses or work in process. These speculation houses do not meet the definition of inventory in the Code. The Internal Revenue Code defines inventory as tangible personal property. Speculation houses are capital assets as defined in IRC Section 263. The builder owns the real property (land) and the house inherently attached to the land. Courts have consistently held that developed real property must be accounted for under a capitalization method. See W.C. & A.N. Miller Development Co. v. Commissioner,81 T.C. 619 (1983); Homes by Ayres v. Commissioner,T.C. Memo. 1984-475, aff’d,795 F.2d 832 (9th Cir. 1986). See also Revenue Ruling 86-149, 1986-2 C.B. 67; Revenue Ruling 66-247, 1966-2 C.B. 198.
Since speculation homes are not built under a contract, long-term contract accounting methods such as the completed contract and percentage of completion do not apply. Speculative homebuilders report their income from the sale of a speculative house at the time of settlement or closing under IRC Section 1001.
Sometimes speculative homes are started but sold during the construction phase, which could become a long-term construction contract if not completed within the same tax year subject to the taxpayer’s long-term contract method of accounting. However, in most cases, the completed contract method is the one elected and the sale would not constitute a taxable event until completion.
The direct and indirect costs incurred by a taxpayer in the construction of a house for speculative sale (including the cost of the land, direct materials and direct labor) should be capitalized according to the principles in IRC Section 263(a) and IRC Section 263A, regardless of the taxpayer’s overall method of accounting.
Under IRC Section 263(a)(1) and Treasury Regulation Section 1.263(a)-1, costs incurred in the construction of homes and other permanent improvements to real property are not currently deductible. Instead the cost of unsold homes and construction in progress is a capital expenditure that becomes part of the basis of the real estate, which in turn, is recovered either through a depreciation allowance if the property is used in a trade or business (rented), or as an offset against the price received in the sale or disposition of such property.
Treasury Regulation Section 1.263(a)-2 sets forth examples of capital expenditures, including the cost of acquisition, construction, or erection of buildings having a useful life substantially beyond the tax year.
The uniform capitalization rule of IRC Section 263A(a)(1) applies to speculation homes, which mandates certain costs to be allocated to property produced by the taxpayer, and that such costs be capitalized if the property is not inventory in the hands of the taxpayer.
IRC Section 263A(a)(1) provides that in the case of any property to which this applies any costs described in paragraph (2) shall be capitalized.
The homebuilder must determine the accumulated production expenditures, described in Treasury Regulation Section 1.263A-11, with respect to each home. This requires the homebuilder to allocate the cumulative amount of direct and indirect costs described in IRC Section 263A(a) that are to be capitalized with respect to the unit of property. A unit of property is defined by Treasury Regulation Section 1.263A-10(b) as any component of real property that is functionally interdependent, along with an allocable share of any common feature owned by the taxpayer. For example, the components of a single family home (land, foundation and walls) are functionally interdependent; in contrast, condo units separately placed in service in a multi-unit building are each treated as a functionally interdependent unit, even though they are all located in the same building. In the case of property produced for sale, components of real property are functionally interdependent if they are customarily sold as a single unit. All costs that have been accumulated for a particular home are charged to cost of sales at the time of settlement with the purchaser of the home.
Revenue Ruling 66-247
The costs incurred in the construction of a house for speculative sale are capitalized regardless of the taxpayer's overall method of accounting. Such costs shall be applied against the amount realized upon the sale of the house for purposes of determining gain or loss in computing taxable income.
Carpenter v. Commissioner, T.C. Memo 1994-289
A building contractor could not use the cash method of accounting for expenses related to construction of houses that were unsold at the end of the tax year because he was a producer of the property. The contractor was required to capitalize the costs of construction related to the unsold houses under IRC Section 263A.
Inventory vs. Real Estate
In the construction industry, it is common for a contractor to use “inventory” terminology for unsold homes or work-in-progress. However, unsold homes or work-in-progress is real estate which is never considered inventory. Both real estate and inventory are assets but this distinction is important because under several accepted inventory methods, a departure from the actual cost could take place (that is, lower of cost or market). In recent years the real estate market has taken a downturn in market value. Generally Accepted Accounting Principles (GAAP) requires real estate to be written down to market value. See Financial Accounting Standards Board (FASB) Statement No. 144 – Accounting for the Impairment or Disposal of Long-Lived Assets. However, for tax purposes, a write-down in value is not permissible; therefore, there should be a book or tax adjustment reported on Schedule M-1 or M-3.
Atlantic Coast Realty Co. v. Commissioner, 11 B.T.A. 416 (1928), and Revenue Ruling 69-536, 1969-2 C.B. 109 hold that home builders are not allowed to treat real estate held for sale as “inventory” and write their work in process down to market value using a lower of cost or market valuation.
Homes by Ayres v. Commissioner, T.C. Memo 1984-475, aff’d. 795 F.2d 832 (9th Cir. 1986) - Taxpayers engaged in the construction and sale of large-scale tract housing developments could not use the LIFO method to account for the property. The court held that real estate is not inventory, and thus an inventory method to account for the property is not allowed.
W.C. & A.N. Miller Development Co. v. Commissioner, 81 T.C. 619 (1983) - The taxpayer was engaged in the business of developing real estate, which it acquired, and constructed single-family, detached homes. The taxpayer applied a LIFO method to account for its completed homes. All costs related to each home were charged to the cost of sales only at the time of settlement with the purchaser of the home. The court held that the individual homes or lots which the taxpayer sells are real estate and do not constitute “merchandise” within the meaning of Treasury Regulation Section 1.471-1. Thus, LIFO is not permitted.
There is a fundamental difference between capitalization and an inventory method. Under capitalization, gain will be determined pursuant to 1001 on each individual home when it is sold and such gain is to be determined based generally on the taxpayer’s actual cost for that particular home.
Revenue Ruling 86-149, 1986-2 C.B. 67 involves a real estate developer who filed a Form 970 to apply for the LIFO method of accounting for its “inventory” of completed homes and homes in progress. The construction costs of completed homes and costs of construction in progress are capital expenditures under IRC Section 263. A taxpayer engaged in the business of developing real estate capitalizes its costs in accordance with IRC Section 263.
Under IRC Section 263(a)(1), costs incurred in the construction of homes and other permanent improvements to real property are not currently deductible. Instead the costs of unsold homes and construction in progress are capital expenditure that becomes part of the cost of the real estate, which, in turn, is recovered either through a depreciation allowance if the property is used in a trade of business, or as an offset against the price received in the subsequent sale or disposition of such property.”
Speculation Homes Becoming Long-Term Contracts
A contractor may begin building a speculative home and enter into a “sales” agreement with a customer prior to completion. If the remaining construction on the home, after the contract is entered into, extends beyond the taxable year, the contractor has entered into a long-term construction contract and would then account for the contract under its exempt long-term method of accounting. See Treasury Regulation Section 1.460-4(c)(1).
As previously mentioned, all costs incurred prior to the contract date, when the home is a speculation home, are capitalized under IRC Section 263(a) and IRC Section 263A. Once the contract is entered into, the accumulated costs to date become deferred costs under the completed contract method and costs incurred after the contract date would be capitalized under the provisions of Treasury Regulation Section 1.460-5(d). However, if the taxpayer were a large homebuilder, the costs incurred after the date of the contract would continue to be capitalized under IRC Section 263A.
If the taxpayer’s exempt long-term method of accounting is a percentage-of-completion method, the accumulated capitalized costs incurred prior to the contract date would become an allocable contract cost in the PCM numerator, and thus be deductible during the year the contract is entered into.
Contractors Building Homes Under Contract
As previously mentioned, any home construction contract is exempt from the requirement to use the percentage of completion method per IRC Section 460(e)(1)(A). Therefore, the contractor may elect a permissible exempt contract method that includes percentage of completion, exempt percentage of completion, completed contract, or any other permissible method under IRC Section 446. See Treasury Regulation Section 1.460-4(c)(1). The contractor must use the elected method to account for all its long-term contracts that are exempt from the requirements of IRC Section 460(a). Even though exempt construction contracts are not subject to the percentage of completion method, production period interest is subject to the cost allocation rules under IRC Section 460(c)(3). See Treasury Regulation Section 1.460-1(a)(2)(i).
Long-Term Methods of Accounting
If a contractor elects a long-term method of accounting for an exempt construction contract (e.g., completed contract method, percentage of completion method, or exempt contract percentage of completion method) it is not relevant who has title to the land on which the home is being built. Within the definition of a contract for the construction of property, Treasury Regulation Section 1.460-1(b)(2) states, “Whether the customer has title to, control over, or bears the risk of loss from, the property manufactured or constructed by the taxpayer also is not relevant.” Treasury Regulation Section 1.460-4 describes the tax recognition of the contract income and expenses attributable to long-term methods of accounting.
Completed Contract Method
Gross contract price and all allocable contract costs incurred are included in taxable income in the year of completion under the completed contract method per Treasury Regulation Section 1.460-4(d).
Percentage of Completion Method (PCM)
A taxpayer generally must include in income the portion of the total contract price that corresponds to the percentage of the entire contract that the taxpayer has completed during the taxable year. The percentage of completion must be determined by comparing allocable contract costs incurred with estimated total allocable contract costs. Thus, the taxpayer includes in gross income a portion of the contract price as the taxpayer incurs allocable contract costs. See Treasury Regulation Section 1.460-4(b).
Exempt Contract Percentage of Completion Method
Similar to PCM, above, except the percentage of completion may be determined using any method of cost comparison (such as direct labor costs incurred to estimated total direct labor costs) or by comparing the work performed on the contract with the estimated total work to be performed. See Treasury Regulation Section 1.460-4(c)(2).
Other Permissible Accounting Methods
Title to the property is relevant if the taxpayer elects any permissible method, per IRC Section 446, other than a long-term method of accounting, because the appropriate rules for income and expenses are contained in other s of the Internal Revenue Code and regulations.
Treasury Regulation Section 1.460-1(a)(2) provides exceptions to the required use of PCM. The requirement to use the PCM does not apply to any exempt construction contract described in Treasury Regulation Section 1.460-3(b). Thus, a taxpayer may determine the income from an exempt construction contract using any accounting method permitted by Treasury Regulation Section 1.460-4(c) and, for contracts accounted for using the completed-contract method (CCM), any cost allocation method permitted by Treasury Regulation Section 1.460-5(d). Exempt construction contracts that are not subject to the PCM or CCM are not subject to the cost allocation rules of Treasury Regulation Section 1.460-5 except for the production-period interest rules of Treasury Regulation Section 1.460-5(b)(2)(v). Exempt construction contractors that are large homebuilders described in Treasury Regulation Section 1.460-5(d)(3) must capitalize costs under IRC Section 263A. All other exempt construction contractors must account for the cost of construction using the appropriate rules contained in other s of the Internal Revenue Code or regulations.
If the contractor does not elect a long-term accounting method and owns the property, the land and the home being built upon it, the contractor must capitalize all costs incurred in the construction of the home per IRC Section 263. See Revenue Ruling 86-149, 1986-2 C.B. 67. These costs are capital expenditures that become a part of the real estate cost that, in turn, is recovered as an offset against the price received upon the disposition of the property. See IRC Section 1001. Therefore, the cash or accrual methods are not allowable methods for contractors building on property it owns.
Conversely, a contractor that builds a home on the customer’s property may be eligible for the cash or accrual method of accounting.
A large homebuilder is one failing to meet the requirements of IRC Section 460(e)(1)(B).
- Any homebuilder whose average annual gross receipts, for three preceding years, exceed $10,000,000 or
- Contracts which are expected to exceed a 2-year period beginning on the contract commencement date.
The only distinction between a large homebuilder and a small homebuilder is that a large homebuilder is required to capitalize the allocable contract costs according to IRC Section 263A.
Homebuilders may buy several lots in a subdivision and build one or more styles of homes to use as a model home. These model homes may contain a portion of the home as a sales office. The model home will eventually be sold at the end of the development. Revenue Ruling 89-25, 1989-1 C.B. 79, states that model homes and sales offices are not subject to an allowance for depreciation.
Furnishings in Model Homes
Unlike Revenue Ruling 89-25 and Duval Motor Co. v. Commissioner, 264 F.2d 548, 551-52 (5th Cir. 1959), furnishings placed in model homes usually do not separately constitute an income-producing activity of a homebuilder, and do not promote the sale of similar furnishings. The model home furniture is not inventory. Instead, the homebuilder intends to promote the sale of homes.
I.R.C. Section 168 provides the applicable depreciation method, applicable recovery period, and the applicable convention for determining the depreciation deduction provided by IRC Section 167(a) for tangible property.
Revenue Procedure 87-56 classifies Office Furniture, Fixtures, and Equipment with a 7-year class life. This asset category includes “furniture and fixtures that are not a structural component of a building . . .." IRC Section 168(e)(3)(C)(ii) also establishes a 7-year class life for any property which does not have a class life. Therefore, the furnishing placed within a model home would be depreciated over a 7-year class life.
In the industry, the developer is generally the owner of the development. The developer acquires the raw land, obtains approval for development, secures the financing, and begins to clear the land, install roads, utilities, etc. The land developer may also build the homes in the development; sell the lots to a builder that will build the homes, or a combination of both.
This pertains to the land developer that improves and sells the lots without having a long-term construction contract under IRC Section 460.
Applicable Method of Income Recognition
Since land developers are involved in the production of property without contracts, they generally report their income from the sale of a parcel of property at the time of settlement or closing.
The direct costs incurred by a land developer in the development of real estate (including the original cost of the land, direct materials and direct labor) should be capitalized according to IRC Section 263(a) and 263A.
The uniform capitalization rules of IRC Section 263A(a)(1) apply to land developers, and mandate certain costs to be allocated to property produced by the taxpayer as real property. These costs include pre-production costs (real estate taxes, zoning costs, design fees, etc.), production costs, and post-production costs.
Von-Lusk v Commissioner, 104 T.C. 207 (1995) held that predevelopment costs were capitalized under IRC Section 263A because taxpayer was involved in the "production" of property.
Reichel v. Commissioner, 112 T.C. 14 (1999) held that real estate taxes paid by a real estate developer were required to be capitalized under IRC Section 263A, even though no positive steps to begin developing the parcels had occurred, because the taxpayer acquired the parcels with the intent to develop them
Hustead v. Commissioner, T.C. Memo. 1994-374, aff'd without opinion, 61 F.3d 895 (3d Cir. 1995) held that expenditures (legal expenses related to challenge of zoning variance) incurred in connection with land development must be capitalized under IRC Section 263A.
The land developer must determine the accumulated production expenditures with respect to each unit of property per Treasury Regulation Section 1.263A-11. Each unit of property, as defined in Treasury Regulation Section 1.263A-10, is treated as a separate costing unit to which all-direct and indirect costs described in IRC Section 263A(a) are required to be capitalized.
Allocating Costs to Each Parcel of Property
Generally Accepted Accounting Principles (GAAP) establishes a hierarchy of cost allocation methods via SFAS 67 Paragraph 11. These methods (in order) are:
- Specific identification method.
- Relative value methods (appraised value, relative assessed value for real estate taxes)
- Other allocation methods (square footage)
If the lots have the same general characteristics and size, cost can be allocated evenly to each lot. If the lots have similar characteristics but different sizes, cost can be allocated on square footage. If lots have different characteristics, costs can normally be allocated based on relative sales value.
In Homes by Ayres, 795 F.2d 832 (9th Cir. 1986), the court addressed job-costing methods. Taxpayers accounted for their construction costs by accumulating costs for each phase of a subdivision. Taxpayers would accumulate all direct and indirect costs for the year and then allocate them according to one of three methods to determine the cost of the houses sold in each phase (relative sales value method, average cost method, and square footage method). All three of these methods comport with generally accepted accounting principles and the IRS admits that they accurately reflect income.
Normally each lot is a separate cost center. But when job costs are accumulated for a subdivision in phases, a cost pool may be used. Costs may be allocated according to standard cost accounting principals. Examples of methods used to determine the cost basis of the lots sold in each phase are:
- One technique for allocating the pool of capitalized costs is the "relative sales value method." This method determines cost of lots sold by multiplying total capitalized costs (already incurred plus estimated costs of completion) by the ratio of the selling prices of the lots sold to the estimated selling prices of all the lots in the phase.
- Another technique for cost allocation, called "average cost method," calls for multiplying total capitalized costs by the ratio of the total number of lots sold to the aggregate number of lots to be sold in a phase.
- Finally, the "square footage method" allocates costs by multiplying total capitalized costs by the ratio of the aggregate square footage of lots to the aggregate square footage of all lots to be sold in the phase.
Alternative Cost Method of Accounting for Real Estate Developers
Under the “alternative cost method” under Revenue Procedure 92-29, 1992-1 C.B. 748, a developer may allocate estimated costs of common improvements to the basis of lots sold despite the limitations imposed by IRC Section 461(h). Developers must obtain permission from the Service to use the alternative cost method on a development-by-development basis. Common improvements must have the following qualities:
- Be real property or real property improvement that benefits two or more properties separately held for sale;
- The developer must be contractually obligated or required by law to provide the improvement; and
- The improvement must not be depreciable by the developer
The common improvement has to be contractually obligated or required by the governing body of law. For example, an agreement to provide improvements in exchange for a building permit is a common improvement. See Herzog Building Corp. v. Commissioner, 44 T.C. 694 (1965)). A statement in a buyer’s HUD report that the developer will provide improvements does not qualify as a contractual obligation. See Revenue Ruling 76-247, 1976-1 C.B. 217). An oral promise to a buyer to provide improvements does not qualify as a contractual obligation. See Bryce’s Mountain Resort, Inc. v. Commissioner, T.C. Memo. 1985-293 (1985)).
Common improvements vary depending on the type of development. Some normal examples of common improvements include:
- Sewer lines
- Tennis Courts
- Swimming Pools
For any taxable year, the estimated cost of common improvements is equal to the amount of common improvement costs incurred under IRC Section 461(h) plus the amount of common improvement costs the developer reasonably anticipates it will incur during the 10 succeeding taxable years. See Revenue Procedure 92-29, 2.02(1).
A developer may include in the basis of properties sold their allocable share of the estimated cost of common improvements without regard to whether the costs are incurred IRC Section 461(h). There is an important limitation, however. As of the end of any taxable year, the total amount of common improvement costs included in the basis of the properties sold may not exceed the amount of common improvement costs that have been incurred under IRC Section 461(h). If the alternative cost statutory limitation prevents a developer from including the entire allocable share of the estimated cost of common improvements in the basis of the properties sold, the costs not included can be deducted in the subsequent taxable year(s) to the extent that additional common improvement costs have been incurred under IRC Section 461(h). See Revenue Procedure 92-29, 4.01.
Taxpayers must comply with certain requirements in order to use the Alternative Cost Method.
- File a request with the appropriate Revenue Procedure 92-29 coordinator, see below, and attach a copy to return, in accordance with section 6.01 of Revenue Procedure 92-29 on or before the due date of the return for the taxable year in which the first lot is sold. The request to use the Alternative Cost Method must include:
- Developer’s identifying information
- Description of the project
- Schedule showing the lots covered by the request and the costs to acquire such lots
- Schedule showing the common improvements required to be provided and information concerning the estimated cost of such improvements, the cost allocable to each lot, and the estimated date of completion of the improvements
- Sign a restricted consent extending the statute of limitations on assessment with respect to the use of the alternative cost method. The restricted consent procedures require:
- Developer must extend the statute of limitations for each year the alternative cost method is used
- Limitations period must be extended to one year beyond the expected completion date of the project
- Form 921: Individuals and Corporations use this form to extend the statute.
- Form 921-P: TEFRA 1120S & partnerships use this form to extend the statute. Tax matters partner signs it.
- Form 921-I: Non-TEFRA 1120S, partnerships, LLC’s, and trusts use this form to extend the statute. Each partner, shareholder, or beneficiary must sign one.
- Form 921-A: This form is obsolete and no longer applicable.
- File an annual statement with the appropriate Revenue Procedure 92-29 coordinator (see below) and attach copy to return in accordance with section 8.02 of Revenue Procedure 92-29. The annual statement must include:
- Developer’s identifying information
- Date of expiration of the extended statute of limitations
- Description of the project
- Schedule showing an updated estimated cost of common improvements, the manner of allocating the costs among lots, the lots sold as of the end of the previous taxable year, the costs incurred under IRC Section 461(h), and the costs included in the basis of lots sold.
A developer that fails to substantially comply with the provisions of Revenue Procedure 92-29 will not be permitted to use the alternative cost method and therefore may not include common improvement costs that have not been incurred under IRC Section 461(h) in the basis of properties for purposes of determining gain or loss from such properties.
Revenue Procedure 92-29 requires the original request and annual statements to be filed with the District Director. However, since the IRS reorganized into the various business divisions in 2000, District Directors no longer exist. The Technical Services Program within the Small Business Self Employed Division (SBSE) of the IRS has several Revenue Procedure 92-29 coordinators that are now responsible for administration of Revenue Procedure 92-29.
The location of the taxpayer’s home office is determines where the original requests, statute extensions, and annual statements are sent. A taxpayer may a separate partnership for each development that may locate in several states. From a consistency standpoint, the taxpayer should file in the appropriate location where their home office is located rather than where each separate development is located.
|MD, DE, DC, NC, SC, VA, FL, International||IRS
Attn: Rev. Proc. 92-29 Coordinator
31 Hopkins Plaza
Baltimore, MD 21201-2825
Attn: Rev. Proc 92-29 Coordinator
211 West Wisconsin Ave.
Attn: MS4020MIL: WSK
Milwaukee, WI 53203
|CT, MA, ME, NH, RI & VT||IRS
Attn: Rev. Proc. 92-29 Coordinator
135 High Street
Hartford, CT 06103
|Laguna Niguel, CA||IRS
Attn: Rev. Proc. 92-29 Coordinator
24000 Avila Road
Laguna Niguel, CA 92677-3405
Attn: Rev. Proc. 92-29 Coordinator
1301 Clay Street
Oakland, CA 94612-5217
|WA, AK, HI, ID, OR||IRS
Attn: Rev. Proc. 92-29 Coordinator
M/S W 140
915 Second Avenue
Seattle, WA 98174
|AZ, CO, NM, NV, WY, UT, MT||IRS
Attn: Rev. Proc. 92-29 Coordinator
MS 4020 DEN
1999 Broadway, 28th Floor
Denver, CO 80202-3025
Attn: Rev. Proc. 92-29 Coordinator
P.O. Box 44985 Stop SB462
Indianapolis, IN 46244
|MO, KS, ND, SD, IA, NE, MN||IRS
Attn: Rev. Proc. 92-29 Coordinator
30 East Seventh Street
St. Paul, MN 55101
Attn: Rev. Proc. 92-29 Coordinator
110 West 44th Street
New York, NY 10036-6710
|TN, GA, TX. AL, OK, MS, LA, AR||IRS
Attn: Rev. Proc. 92-29 Coordinator
401 W Peachtree St
Atlanta, GA 30308-3510
|PA, OH, KY, WV, NJ, MI||IRS
Attn: Rev. Proc. 92-29 Coordinator
600 Arch Street
Philadelphia, PA 19106-1611
Statute of Limitations Example
A developer (partnership) applied for Revenue Procedure 92-29 approval for calendar tax year 1998 and agreed to the statute extension as required. A six-year common improvement period was requested. The Form 921 consent was secured at the time that the approval was issued and covered tax years ending 1998, 1999, 2000, 2001, 2002, and 2003. Tax returns for all project years were filed timely. During 2004 the developer came under audit for the 2003 return. The audit was completed by late 2004. The agent found that major aspects of the development disqualified it for Revenue Procedure 92-29 treatment and proposed audit adjustments for all six-project years (1998 through 2003). The 1998, 1999, 2000, and 2001 statutes for Revenue Procedure 92-29 adjustments expire April 15, 2005. The statute of limitations for all project years is computed as follows:
- Projected completion year for the common improvements: 2003
- Return (1065) due date for project completion year: April 15, 2004
- Add one year to project completion year return filing date: April 15, 2005
|Year||Date Return Filed||Normal Statute Expiration||Form 921 Statute Expiration||Rev. Proc 92-29 Statute Expiration|
|1998||April 15, 1999||April 15, 2002||April 15, 2005||April 15, 2005|
|1999||April 15, 2000||April 15, 2003||April 15, 2005||April 15, 2005|
|2000||April 15, 2001||April 15, 2004||April 15, 2005||April 15, 2005|
|2001||April 15, 2002||April 15, 2005||April 15, 2005||April 15, 2005|
|2002||April 15, 2003||April 15, 2006||April 15, 2005||April 15, 2006|
|2003||April 15, 2004||April 15, 2007||April 15, 2005||April 15, 2007|
Assume the same facts as above except that the developer has not yet filed the completion year (2003) tax return. The statute of limitations for all project years is as follows.
|Year||Date Return Filed||Normal Statute Expiration||Form 921 Statute Expiration||Rev. Proc 92-29 Statute Expiration|
|1998||April 15, 1999||April 15, 2002||Open||Open|
|1999||April 15, 2000||April 15, 2003||Open||Open|
|2000||April 15, 2001||April 15, 2004||Open||Open|
|2001||April 15, 2002||April 15, 2005||Open||Open|
|2002||April 15, 2003||April 15, 2006||Open||Open|
Revenue Procedure 92-29, Section 10 provides that if the first year in which the alternative cost method is improperly used is no longer open for assessment of a deficiency of tax, the Commissioner may use her statutory discretion to change the taxpayer’s method of accounting in a later year and impose an adjustment under IRC 481(a). This allows the IRS to make a cumulative adjustment or correction for all barred years in the earliest open year.
Allocation of Common Improvements
A developer will build 20 units of three cost classes (5 condo units, 6 town home units, and 9 single family homes) on a tract of land. The developer is contractually obligated to provide the common improvements and estimates that the common improvements will cost $1,400,000 (including the cost of land associated with the common improvements). The common improvements are allocated as follows: $200,000 for the 5 condominium units, $300,000 for the 6 town homes, and $900,000 for the 9 single-family lots. The cost of the common improvements is not properly recoverable through depreciation by the developer. Common improvement costs are allocated as follows: 5 condo units @ $40,000 each, 6 town home units @ $50,000 each, and 9 single family lots @ $100,000 each.
Revenue Procedure 92-29 vs. IRC Section 461(h)
A developer building ten properties of equal value on a tract of land is contractually obligated to provide common improvements. The common improvements will benefit all the lots in the development equally. The developer estimates that these common improvements will cost $1,000,000 (including the cost of the land associated with the common improvements). The cost of the common improvements is not properly recoverable through depreciation by the developer. Each lot’s allocable share of the estimated cost of the common improvements is $100,000 ($1,000,000/10 lots). In Year 1, the developer incurs $250,000 in common improvement expenses and sell 2 lots.
Under IRC Section 461(h), the deduction would be $50,000 ($250,000/10 lots = $25,000 X 2 sales = $50,000). However, under Revenue Procedure 92-29, the deduction in Year 1 is $200,000. The $100,000 allocation to each lot sold does not exceed the total IRC 461(h) limitation of $250,000.
IRC Section 461(h) Limitation
Year 1: The development has twenty single-family lots and estimated common improvement costs are $1,500,000. The application states that costs are allocated equally to each lot; therefore $75,000 would be allocated to each lot ($1,500,000/20). During Year 1, $300,000 in common improvement costs was incurred and five lots were sold.
Without the IRC Section 461(h) limitation, the Revenue Procedure 92-29 deduction for common improvements for Year 1 would be $375,000 ($1,500,000/20 x 5 lots sold). However, the total cost incurred for the common improvements are $300,000, thus the deduction is limited to $300,000. The $75,000 barred in Year 1 is carried forward to Year 2 provided the additional costs are incurred.
Year 2: $600,000 is obligated for common improvement costs that were incurred. Six lots were sold. The Year 2 deduction consists of both the deduction for current year’s sales and the unused Year 1 is carried forward.
Sold six lots at $75,000 each
Amount barred from Year 1 sales
Total Deduction for Year 2
Supplemental Request to Use the Alternative Cost Method of Accounting
There are many circumstances outside the developer’s control (changes mandated by the EPA, the local municipality, etc. and/or damage to the construction site resulting from tornadoes, floods, etc.) that can result in project completion delays. A supplemental request pursuant to Section 9.01 of Revenue Procedure 92-29 is required to extend the common improvement construction period past the original estimated completion date.
The IRS will respond to the taxpayer within 45 days of receipt of the supplemental request and notify the taxpayer of either approval or disapproval. An updated Form 921 (statute consent) must be secured. The IRS response of approval or disapproval of the supplemental request must be in writing. Supplemental Requests are not appropriate for avoiding the required periodic adjustments for overstated estimated expenses versus what were actually incurred to date thus deferring the final year reconciliation, and adding new developments and/or expanding current projects.
Annual Reports and Statements
Annual reports are required for every year that construction is occurring and estimated costs of common improvements are being claimed against sales income, pursuant to Section 8 of Revenue Procedure 92-29. Annual statements are no longer required when any one the following situations occur:
- The approval period expires. If all obligated costs are not incurred by the end of the expiration period, the developer has a change in method of accounting to account for common costs per IRC Section 461(h). A new unit cost allocation is calculated based upon total actual costs incurred during the approved Revenue Procedure 92-29 period. A prior period correction is recognized for the difference in all deductions claimed under Revenue Procedure 92-29 vs. IRC Section 461(h).
- All obligated common improvement costs are incurred. As the developer is no longer including estimated future costs in Cost of Goods Sold (COGS) the restricted Revenue Procedure 92-29 consent, secured when the application was processed, is no longer applicable. The Revenue Procedure 92-29 project file can be closed.
- If all inventories are sold before all obligated expenses are incurred, the developer has a change in method of accounting to IRC Section 461(h) in the year that the final unit is sold. A new unit cost allocation is calculated based upon total actual common improvement costs incurred. A prior period correction is recognized for the difference in all deductions claimed under Revenue Procedure 92-29 vs. IRC Section 461(h).
The developer reports revisions to the original estimate and re-computes the per unit allocations on each annual statement. He also reports prior and current obligated costs incurred; prior and current sales of units; prior and current Revenue Procedure 92-29 deductions claimed; and reports any corrections or revisions to prior information reported.
The developer is required to adjust the production budget, replace estimated costs with actual costs, and present an accurate picture of the project. The developer is required to be able to substantiate the reasonableness and accuracy of the estimated cost figures that were submitted on the Revenue Procedure 92-29 application.
In the initial years, estimated costs comprise a large part of the per unit cost allocations. As work on the development progresses and actual costs are incurred, the developer must recognize the variances and report the latest budget on the annual statement. As the project nears completion, the per-unit cost allocations used and prior period adjustments reported result in an ongoing reconciliation and correction of the timing differences.
Common Improvements Allocable to the Cost of the Lots Developed by the Taxpayer
The question is whether common improvements such as a golf course or clubhouse are allocable to the cost of the lots being developed by the taxpayer. This is a factual determination that needs to be made on the merits of each situation. Review of the following applicable court cases indicates a common theme that is based upon two points:
- The basic purpose of constructing the common improvement is to induce the sale of the lots; and
- The taxpayer does not retain "too much ownership or control" of the common improvement.
The taxpayer was not allowed to allocate the common costs to the basis of the lots sold in the following cases:
- Charlevoix Country Club, Inc. v. Commissioner, 105 F. Supp. 2d 756 (W.D. Mich. 2000).
The taxpayer constructed a golf course, country club, and residential lots. The taxpayer owns both the golf course and country club. The taxpayer sells golf club memberships both to lot owners and to the public at large. The membership permits the purchaser to use the golf course and country club but does not give them any ownership rights.
The costs of the golf course and country club could not be allocated to the lots because the taxpayer “retains complete control “of the golf course and country club. In Charlevoix, the court distinguished this case from Norwest:
Here, the court assumes, for purposes of deciding this motion, that CCC constructed the golf course and country club for the sole purpose of improving the salability of the residential lots contained within the development. However, even assuming the existence of such a purpose, the stipulated fact remains that CCC has not transferred any ownership interest whatsoever in the golf course or country club; instead, it has sold to others merely a right to use these properties.
- Colony Inc. v. Commissioner, 26 T.C. 30 (1956), rev’d. in part on other grounds, 357 U.S. 28 (1958).
The court held that a water and sewage system, fully owned and controlled by the developer, was not to be added to the cost of the lots sold, even when its subsequent operation by the taxpayer was not profitable.
- The court reached a similar conclusion in Sabinske v. United States, 62-1 U.S.T.C. Paragraph 9210 (N.D. Tex. 1962).
- Noell v. Commissioner, 66 T.C. 718 (1976).
The subdivider’s cost of building airport runway and taxiways adjacent to lots could not be added to the basis of the lots because the taxpayer retained full ownership and control.
A critical question is whether the petitioner intended to hold the facilities to realize a return on his capital from business operations, to recover his capital from a future sale, or some combination of the two. The other question is whether he so encumbered his property with rights running to the property owners regardless of who retained nominal title that he in substance disposed of these facilities, intending to recover his capital, and derive a return of his investment through the sale of lots.
The taxpayer was allowed to allocate the common costs to the basis of the lots sold in the following cases:
- Norwest Corp & Subsidiaries, 111 T.C. 105 (1998).
The taxpayer wanted to allocate the cost of constructing an Atrium to enhance the sale of surrounding office buildings. The cost of common improvements is allocated to the basis of lots held for sale when:
- The basic purpose of the taxpayer in constructing the common improvement is to induce the sales of the lots, and
- The taxpayer does not retain too much ownership and control of the common improvement, then the lots held for sale are deemed to include the allocable share of the cost of the common improvement.
The rationale of the developer line of cases is that, when the basic purpose of property is the enhancement of other properties to induce their sale and such property does not have, in substance, an independent existence, total cost recovery for such property should be dependent on sale of the benefited properties.
- Hutchinson v. Commissioner, 116 T.C. 172 (2001).
The developer of a residential subdivision was permitted to allocate the estimated construction costs relating to common improvements in the basis of the lots sold pursuant to Revenue Procedure 92-29. The common improvements included the construction of a golf course, clubhouse, swimming pool, and tennis courts.
When the taxpayer began the development, he entered into a contract with a nonprofit membership corporation whose members would purchase memberships in the golf club. The golf course and clubhouse would then be transferred to the nonprofit membership corporation when a certain number of memberships were sold or December 31, 2001 whichever was earlier.
After completion of the golf course in 1996, the developer managed and operated it until April 1999 because the required number of memberships had not been sold. However, during these transition years the nonprofit membership corporation was responsible for decisions and costs of any further improvements made to the golf course and clubhouse.
The court held that the developer did not possess the benefits and burdens of ownership during the transition period and thus the estimated construction costs could be allocated to the bases of the residential lots sold under the alternative cost method of Revenue Procedure 92-29.
- Revenue Ruling 68-478, 1968-2 C.B. 330.
The developer of a subdivision and golf course conveyed part of the land and improvements, including the golf course, lake, dam, and related recreational facilities to a non-profit country club. The taxpayer did not retain any ownership in the property transferred.
- Country Club Estates, Inc. v. Commissioner, 22 T.C. 1283 (1954).
The developer of a residential subdivision donated land to a nonprofit country club to build a golf course thereon. The cost of the land donated was to be treated as part of the cost of the lots sold.
- Collins v. Commissioner, 31 T.C. 238 (1959).
The developer of a subdivision conveyed to the owners of the lots, an equitable interest in a sewage disposal system. The court held that the taxpayer did not retain full ownership and control of the sewage system and that they parted with material property rights.
The court held that if a person engaged in the business of developing and exploiting a real estate subdivision constructs a facility for the basic purpose of inducing people to buy lots, the cost of such construction is properly a part of the cost basis of the lots. This is so even though the sub-divider retains tenuous rights without practical value to the facility constructed such as contingent reversion.
If the sub-divider retains ‘full ownership and control’ of the facility and does ‘not part with the property or facility constructed for benefit of the subdivision lots, then the cost of such facility is not properly a part of the cost basis of the lots.
- Willow Terrace Development Co. v. Commissioner, 345 F.2d 933 (5th Cir. 1965).
The developer of a subdivision was allowed to allocate the cost of water and sewer systems to the basis of lots sold. The water and sewer systems were dedicated to the benefit of the homeowners under the FHA trust deed; the rights retained by the taxpayer have at that time little if any saleable value.
Some relevant factors to be considered in determining the proper tax treatment of the costs of such facilities are whether they were essential to the sale of the lots or houses, whether the purpose or intent of the sub-divider in constructing them was to sell lots or to make an independent investment in activity ancillary to the sale of lots or houses, whether and the extent to which the facilities are dedicated to the homeowners, what rights and of what value are retained by the sub-divider, and the likelihood of recovery of costs through subsequent sale.
- Montclair Development Company v. Commissioner, TC Memo 1966-200.
The developer of a subdivision was allowed to allocate costs of sewer and water systems. The taxpayer transferred the system to a trustee for the benefit of homeowners in compliance with requirements of the FHA.
A construction contract that meets the requirement of a home construction contract is exempt from the percentage of completion method of accounting for both regular income tax and alternative minimum tax. Speculation homes, land developers, and some large homebuilders build homes that are not under a long-term contract, and long-term contract methods of accounting do not apply to such contracts. Revenue Procedure 92-29 allows a developer an alternative cost allocation of common improvements in an attempt to even out the gross profit of each lot produced over the life of the project.