Tax Court broadly applies UNICAP rules to real estate developer.

Businesses that develop real estate should be aware of a recent Tax Court decision that very broadly applies Sec. 263A, and reaches an unfavorable result for the real estate developer involved. In Von-Lusk, 104 TC No. 8 (1995), the court held that costs (e.g., engineering and architectural fees) incurred by a partnership prior to the time actual production began were related to production and were required to be capitalized into the basis of the assets that would be constructed. The case significantly expands what many developers would have considered to be Sec. 263A costs in this context.

The Von-Lusk limited partnership was formed in 1966 for the purpose of managing, holding and developing approximately 278 acres of raw land in southern California. During 1988, 1989 and 1990, no construction took place on the land. Rather, the land was leased and used to grow grains and grass, while the partnership endeavored to receive the necessary permission from local governments to begin construction. The partnership proposed to construct residential housing on the land. Some preliminary governmental approval was received.

Based on the text of the court opinion, it appears that the Von-Lusk limited partnership had no employees, and conducted its business through the general partner's obtaining the services of independent contractors, who provided lobbying, engineering and architectural services and would meet with government officials. They also obtained building permits and zoning variances, negotiated permit fees, performed engineering and feasibility studies and drafted architectural plans. The contractors then billed the partnership.

Administrative and management services were provided to the partnership by a company that employed executives, project managers, secretaries and accountants. This company's employees monitored the work on the partnership's development project, and reviewed and directed the work of the contractors. It then billed the cost of these employees to the partnership.

The court held that all of the pre-production costs discussed had to be capitalized under Sec. 263A, since the partnership was producing real estate. In enacting Sec. 263A, Congress meant to include in costs to be capitalized the preliminary, nonphysical steps of development. The partnership had argued that production began (and costs had to be capitalized) only when there was physical activity (e.g., excavation of foundations).

It should be noted that Von-Lusk was required to capitalize all the costs it incurred, since the company failed to show that any of these costs were not related to production. With proper documentation, a developer would be allowed current deductions for the costs of items not related to production (such as advertising, marketing, strategic business planning, or any general or administrative expenses not related to production).

For companies that believe they have audit exposure on Sec. 263A accounting method issues, they should consider the audit protection offered by Rev. Proc. 94-49. The procedure generally allows a company to voluntarily change its Sec. 263A method in its first year beginning after 1993, and spread any income adjustment over a maximum four-year period. A voluntary change with the required income adjustment would preclude the IRS from changing the method in an earlier year.