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Future costs.

Real estate developers will face many challenges in the years to come in their attempts to recover from a slowed economy. One such current challenge is compliance with Rev. Proc. 92-29. Effective for sales of property after 1992, it requires "a developer of real estate to obtain the Commissioner's consent to use an alternative to the general method under section 461(h) of the Internal Revenue Code for determining when common improvement costs may be included in the basis of properties sold for purposes of determining the gain or loss resulting from the sales."

What are the consequences of not following these new guidelines? "A developer that fails to substantially comply with the provisions of this revenue procedure will not be permitted to use the alternative cost method and therefore may not include common improvement costs that have not been incurred under section 461(h) of the Code in the basis of benefited properties...."

Rev. Proc. 92-29 defines common improvements 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 developer must be contractually obligated or required by law to provide the common improvement and the cost of the common improvement must not be properly recoverable through depreciation by the developer." Common improvements include streets, sidewalks, sewer lines, club-houses, golf courses, tennis courts and swimming pools.

Rev. Proc. 75-25 previously allowed a subdivider of real estate to request permission from the district director to include the estimated cost of certain common improvements in the basis of lots sold, when determining the gain or loss resulting from the sale of lots. Many developers failed to follow the procedure to the letter but continued to deduct estimated future costs, arguing that there was a proper matching of income with expenses. Subsequent to the issuance of proposed regulations under Sec. 461(h) on June 7, 1990, Notice 91-4 provided guidelines to be followed for sales after 1990. Some developers continued to believe that it was still possible to deduct future costs without properly filing with the IRS. It is now clear that Rev. Proc. 92-29 is to be followed if a developer is to include the allocable share of the estimated cost of common improvements in the basis of properties sold. To comply with the new revenue procedure, the developer should apply the "alternative cost method" when allocating costs of common improvements.

Under the "alternative cost method," the developer can include an allocable share of estimated costs of common improvements in the basis of properties sold without regard to the rules of Sec. 461(h). At the end of any tax year, the total amount of common improvement costs allocated to the basis of the properties sold cannot exceed the cost of common improvements actually incurred under Sec. 461(h). If the developer is restricted by this limitation, the costs not included may be used in the subsequent tax year to the extent additional common improvement costs have been incurred under Sec. 461(h).

Now that developers will be complying with the procedures for deducting the common improvement costs to be incurred in the future, and the information can (and probably will) be more closely scrutinized by the Service, it is necessary to accurately identify, compute and allocate the costs. A developer is well advised to review the various methods of allocating these costs under the "alternative cost method."

The most beneficial way of allocating costs under the "alternative cost method" will depend on a developer's circumstances. An examination of the "unit allocation method," the "benefit allocation method" and the various "hybrid allocation methods" will serve the real estate developer well in maximizing the tax savings of deducting the future common improvement costs.

The "unit allocation method" is based on the economic desirability of the terrain, when the development is divided into several zones based on location and homogeneity. Common improvement costs are allocated proportionally to the parcels, based on a rating yield (i.e., the number of houses or lots to be generated per acre). For example, a development is divided into three zones. One zone is hilly, one zone is flat and one has several lakes. Each zone is rated based on the number of lots to be generated per acre. This rating is then multiplied by the number of acres in the zone and totaled to determine the rating for each zone. The rating total for each zone is divided by the total rating totals for all the zones to get a percentage to allocate per zone. Common improvement costs are then allocated based on the percentage computed for each zone. The table above illustrates the allocation of the cost of a clubhouse by a unit allocation method.
Unit Allocation of Off-Site Improvements
 The total cost of a clubhouse is $5,000,000, allocated in the following
Zone yield(*) Acres Total Percent Allocation
 1 1 50 50 25% $1,250,000
 2 2 25 50 25 1,250,000
 3 3 33 100 50 2,500,000
 108 200 100% $5,000,000
(*) Based on the number of lots to be generated per acre.

The "benefit allocation method" can be used when it can be determined which particular parcels benefit the most from the common improvement cost. After determining which properties receive the greatest value in relation to others, the costs are allocated accordingly; e.g., the costs of a lake in a development would be allocated more to the properties adjacent to the lake than the properties further away.

Use of a "hybrid allocation method," if separate common improvement costs will be allocated differently, may achieve the best results. Under this method, costs might be allocated in several different ways. For example, in a project, streets might be allocated on a pro rata basis and the lakes might be allocated using the "benefit allocation method."

Care must be take to support the method used with documentation and sound reasoning. The request to use Rev. Proc. 92-29 will disclose the methods being used to allocate costs and will be available to the IRS, both in the initial application and in subsequent filing of the developers' tax returns. Rev. Proc. 92-29 should be reviewed thoroughly for compliance and transition rules.
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Title Annotation:improvement inclusion in property valuation
Author:Stump, Mitchell L.
Publication:The Tax Adviser
Date:Sep 1, 1992
Previous Article:Charitable deductions and UBIT.
Next Article:Determining sufficient nexus in a state.

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