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Economic performance: limited relief under Rev. Proc. 92-29.

Before the economic performance regulations under Sec. 461[h] were released, Rev. Proc. 7545[1] and case law[2] allowed real estate developers to include estimated future costs of common improvements (e.g., streets, sidewalks, sewer lines, etc.) in the basis of property sold. In 1984, Congress enacted Sec. 461(h), which provided that economic performance had to occur before an accrual-method taxpayer could deduct unpaid expenses. It was unclear whether Congress intended Sec. 4611h1 to supersede Rev. Proc. 75-25 and prior case law with respect to future development costs.

On June 7, 1990, when the IRS issued the proposed regulations, it noted that the economic performance requirement obsoleted Rev. Proc. 75-25, but only for tax years beginning after Dec. 31, 1989. Practitioners argued that this method resuited in a gross mismatching of revenues and expenses as a majority of the common improvement costs would be incurred in the later stages of the project.

As the result of comments by practitioners and pressure by real estate developers, the IRS issued Notice 91-4,[3] which provided that Sec. 461(h) would not be applied for sales before Jan. 1, 1991. Notice 91-4 also required developers to obtain permission to use Rev. Proc. 75-25 for sales after Dec. 31, 1990, or apply Sec. 461[h] to future development costs.

On Apr. 9, 1992, the Treasury issued final regulations under Sec. 461 [h] and required real estate developers to follow Rev. Proc. 92-29[4] with respect to future development costs. Rev. Proc. 92-29 provides limited relief from Sec. 461(h) through the use of the "alternative cost method." This article will discuss the alternative cost method and Rev. Proc. 92-29's numerous reporting requirements.

Alternative Cost Method

The "alternative cost method" allows a developer to include the estimated cost of common improvements in the basis of property sold providing the developer is contractually obligated or required by law to provide common improvements. Further, the cost of these improvements cannot be recoverable through depreciation by the developer. Common improvements are defined as any real property or improvements to real property that benefit two or more properties that are separately held for sale by a developer.

The estimated cost of common improvements as of the end of any tax year is equal to --the amount of common improvement costs incurred under Sec. 461[h], plus --the amount of common improvement costs the developer reasonably anticipates it will incur under Sec. 461[h] during the 10 succeeding tax years i"the 10-tax-year horizon"].

These costs may change from year to year as the developer's information and obligations change. IL after filing a tax return, events show that the estimate for the prior year common improvement costs was either overstated or understated, the developer may not adjust the prior year return. The developer must make the adjustment in and/or the year the determination is made.

As of the end of any tax 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 to date under Sec. 461(h). Estimated costs in any given year that are limited due to this requirement may be taken into account in a subsequent year to the extent additional costs have been incurred under Sec. 461(h). The alternative cost limitation is applied on a project-by-project basis. A developer may use any reasonable method to define a project in light of the common improvements to be provided.

Example 1: Developer D builds 10 equally valued houses on a tract of land. D is contractually obligated to provide common improvements that will benefit each house equally. D estimates the common improvement costs to total $500,000. The costs are not recoverable through depreciation by the developer.

In the first year D sells four houses and incurs $250,000 in costs within the meaning of Sec. 461[h] Based on these 'facts, D could include $200,000 in the basis of the houses sold, computed as follows.
 1. Total estimated costs $500,000
 2. Estimated cost per house
 ($500,000 + 10) 50,000
 3. Estimated cost per house
 multiplied by the
 number of houses sold
 [$50,000 x 4] 200,000
 4. Sec. 461(h) costs
 incurred to date 250,000
 5. Lesser of 3 or 4 200,000


In future years, the developer would compare the common improvement costs allocable to houses sold during the year plus costs included in houses sold in prior years to the total costs incurred within the meaning of Sec. 461(h). The allowable common improvement costs for any given year may not exceed the total common improvement costs incurred within the meaning of Sec. 461(h)[5].

Example 2: Assume the same facts as in Example 1, except that the alternative cost method is not elected. D could include only $100,000 of common improvement costs in the basis of the houses sold, computed as follows.
 1. Costs incurred under Sec. 461(h) $250,000
 2. Costs per house incurred to date
 [$250,000 + 10) 25,000
 3. Houses sold multiplied by
 cost per house
 (4 :,: $25,000) 100,000


* Conditions for using the alternative cost method

1. The developer must be contractually obligated or required by law to provide the common improvements. The cost of the common improvements may riot be recoverable through depreciation by the developer.

2. The developer must file a request to use the alternative cost method on a project-by-project basis.

3. The developer must sign a consent extending the period of limitation on the assessment of income tax with respect to the use of the alternative cost method on a project-by-project basis.

4. The developer must file an annual statement for each project for which the developer has received permission to use the alternative cost method.

5. The developer must file a supplemental request/or each project/or which the developer has received permission to use the alternative cost method if the project is not completed by the extended limitation period discussed in condition 3.[6]

Procedure [or Obtaining Consent

* The 10-tax-year horizon

A developer that wishes to use the 10-tax-year-horizon method may obtain automatic consent to use the alternative cost method by following the procedures listed below.

* The developer must file a request and a consent to extend the statute of limitations with the District Director for the Internal Revenue district in which the taxpayer's principal place of business is located. Exhibit A, on page 672, details the required information.

* The request must be filed on or before the due date of the developer's original Federal income tax return [determined with regard to extensions] for the tax year in which the first benefited property in the project is sold.

* The developer must attach a copy of the request to its original timely filed Federal income tax return [determined with regard to extensions]. No user fee is required?

* Non-10-tax-year horizon To request the alternative cost method for a project without using the 10-tax-year-horizon method to determine the estimated cost of improvements, the developer must file a request for a private letter ruling under the provisions of Rev. Proc. 99.1.[8] The request must be filed within 30 days after the close of the tax year in which the first benefited property in the project is sold. The request must include the information listed in Exhibit A and a consent to extend the statute of limitations. A user fee is required for this request.

A developer will ordinarily be granted consent to use the alternative cost method [non-10-tax-year horizon] for the project covered by the request on a showing that --the developer is contractually obligated or required by law to' provide the common improvements, --the developer's estimate of the cost of common improvements is accurate; and --the developer is likely to provide the common improvements?

Consent to Extend the Limitation Period

A developer requesting permission to use the alternative cost method on a project must agree to extend the period of limitation on the assessment of income tax for each tax year in which the alternative cost method is used. The consent is limited to the assessment of deficiencies attributable to the use of the alternative cost method with respect to the project covered by the consent.

The consent will permit the assessment of a deficiency for each tax year in which the alternative cost method is used--within one year after the return is filed for the tax year that the taxpayer specifies it expects to complete the project.

The developer must execute and file a consent on the applicable Form 99.1, Consent to Extend the Time to Assess Income Tax, or Form 921A, Consent Fixing Period of Limitation On Assessment of Income and Profits Tax. The consent must be filed with the district director?

Annual Statement Requirement

A developer that has received permission to use the alternative cost method for a project must file an annual statement with the District Director. Exhibit B, on page 674, lists the required information. The annual statement must be filed on or before the due date of the developer's original Federal income tax return (determined with regard to extensions) for the first tax year following the tax year for which the developer received permission to use the alternative cost method and for each succeeding tax year in which the developer uses the alternative cost method. The developer must also attach a copy of the statement to its timely filed [determined with regard to extensions] original Federal tax return.[11]

Supplemental Request Requirement

If a developer has not completed the project before the expiration of the extended period of limitation, the developer must file a supplemental request on or before the expiration of the consent to extend the period. The developer must continue to use the alternative cost method with respect to common improvements not completed at that time. The supplemental request must be filed with the district director.

The supplemental request must include the consent to extend the period of limitation on the assessment of income tax with respect to the use of the alternative cost method.

In its request, the developer must substantiate that --for a valid reason, it was unable to complete all of the common improvements it is contractually obligated or required by law to provide within the period covered by the consent; --it continues to be contractually obligated or required by law to provide the common improvements; and --it has, to date, complied with the requirements of Rev. Proc. 92-29.

A developer requesting permission to continue to use the alternative cost method must agree to extend the period of limitation on the assessment of income tax with respect to the use of the alternative cost method for each tax year in which the alternative cost method is used by executing and filing a consent on the applicable Form 921 or Form 921A.

The consent will allow for the assessment of a deficiency for each tax year in which the alternative cost method is used within one year after the return is filed for the tax year that the taxpayer specifies it expects to complete the project.[12]

* Transition procedure

The special transition procedure allows a developer to use the alternative cost method with respect to a project regardless of whether the request for the project was filed for the tax year in which the first benefited property in the project is sold. The request must be filed for the tax year that includes Jan. 1, 1991, or the tax year that includes Jan. 1, 1993 {or any intervening tax year}.

If the return has not been filed, the developer should follow the procedures discussed above. If the tax return for the tax year has already been filed, the developer must --file the request with the district director on or before June 9.9, 1993, and --attach a copy of the request to an amended return for the tax year filed on or before June 29, 1993?[13] In either case the developer must include the information listed in Exhibit A.

A developer that wants to determine the estimated cost of common improvements without regard to the 10-tax-year horizon must file the request for a private letter ruling on or before the later of 30 days after the close of the tax year or June 29, 1993.

The change to the alternative cost method with respect to the project is an accounting method change. The developer must implement the change using the "cut-off method" described in Q&A-I and Q&A-11 of Temp. Regs. Sec. 1.4617T, except that the effective date is the first day of the tax year for which the change is made. Since the "cut-off" method is used, no Sec. 481{a} adjustment is required.

Effective Dates

Rev. Proe. 92-29 obsoletes Rev. Procs. 75-25 and 78-25 with respect to sales of property after Dec. 31, 1992. For sales of property from Jan. 1, 1991 to Dec. 31, 1992, developers have the option of following Rev. Proc. 92-29 or Rev. Proc. 75-25 [under Notice 91-41.] See the transition procedure discussed above. J Developers that wish to use either of these revenue procedures must comply with the procedures for obtaining consent specified therein.

If a developer fails to timely request to use the provisions of Rev. Proc. 75-25 or Rev. Proc. 92-29, then Sec. 461(h) will govern the treatment of costs of common improvements to property sold after Dec. 31, 1990.

Developers that have received explicit consent from the District Director under Rev. Proc. 75-9.5 may continue to use the provisions of Rev. Proc. 75-25 for sales of property covered by the consent, including sales occurring after Dec. 31, 1992?

Conclusion

Rev. Proc. 92-29 provides welcome relief for real estate developers from the economic performance rules with respect to estimated costs of future improvements. Although the annual ceiling under the alternative cost method may be prohibitive, broad definition of the term "project" should increase the amount of costs incurred under Sec. 461{h) and the cumulative limitation.

Although Rev. Proc. 99.-29 eliminates many onerous filing requirements contained in Rev. Proc. 75-25, taxpayers must still meet significant reporting requirements on an annual basis.

Tax Division Fall Meeting to Feature Top Speakers

The Tax Division Fall Meeting will feature top speakers from the IRS, Treasury, Jofnt Committee on Taxation, and the House Ways and Means Committee. Tax experts from the accounting profession will also address the expected 500 members of the Tax Division who will attend the plenary session program at the Marriott's Desert Springs Resort in Palm Desert, California on December 7-9, 1992. Committee meetings on December 7 and 9 and breakout sessions on December 8 will brief members on current technical and practical issues. Eight hours of CPE credit will be given for attending all sessions on December 8.

This conference is expected to reach capacity quickly, and there is no guarantee that on-site registration will be available, so please register early. Registration material will be sent to all Tax Division members. For registration material or information on jofning the Tax Division, please call Kristina Korte at (202) 434-9232.

[1] Rev. Proc. 75-25, 1975-1 CB 720, as amplified by Rev. Proc. 7825,-1978-2 CB 505.

[2] See, e.g., Herzog Building Corp., 44 TC 694 {1965}, Gambria Development Go., 34 BTA 1155 {1936L and Bryce's Mountain Resort, Inc., TC Memo 1985-293. 670

[3] Notice 91-4, 1991-1 CB 315.

[4] Rev. Proc. 92-29, IRB 1992-17, 15.

[5] Example adapted from Rev. Proc. 92-29, at Section 4.02.

[6] Rev. Proc. 92-29, at Section 5.

[7] Rev. Proc. 92-9.9, at Section 6.01.

[8] Rev. Proc. 92-1, IRB 1992-1, 9.

[9] Rev. Proc. 92-29, at Section 6.02.

[10] Rev. Proc. 92-29, at Section 7.

[11] Rev. Proc. 92-29, at Section 8.

[12] Rev. Proc. 92-29, at Section 9.

[13] Rev. Proc. 92-29, at Section 6.03.

[14] Rev. Proc. 92-29, at Sections 3 and 11.

Perry Plescia, MST, CPA KPMG Peat Marwick Chicago, Illinois Brian Ladin, CPA KPMG Peat Marwick Chicago, Illinofs
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Author:Ladin, Brian
Publication:The Tax Adviser
Date:Oct 1, 1992
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