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Must developers comply with Rev. Proc. 75-25?

According to the IRS, real estate developers wishing to include the cost of estimated future improvements in the basis of lots sold must comply with Rev. Proc. 75-25. In the preamble to the economic performance proposed regulations issued in June 1990, the Service stated that future costs could not be included in the basis of lots until economic performance occurs. However, in Notice 91-4, the Service said that Rev. Proc. 75-25 would remain in effect until further notice.

Under the revenue procedure, a developer must meet certain conditions in order to obtain permission to include these costs.

* The developer must be contractually obligated to make such improvements.

* The future costs must not be of a nature that they may be recovered by the developer through depreciation.

* The developer must sign a consent extending the period for assessing income taxes.

* Certain information must be furnished in the request, such as a description of the tract, a list of future improvements, a copy of the contract requiring improvements, etc.

* Annual follow-up information must be submitted.

Because of the strict and burdensome filing requirements, many developers have not complied with Rev. Proc. 75-25. The issue is whether these costs may be included in basis without such compliance.

A judicial exception may exist for including future costs in basis. According to Cambria Development Co., 34 BTA 1155 (1936), developers have been permitted to include in the basis of their lots the estimated costs of improvements since 1919. At the time Cambria Development Co. was decided, the Service had issued Mim. 4027 (1933). (Rev. Proc. 75-25 updated an restated this mimeograph.) One of the conditions of Mim. 4027 was a requirement that the developer waive the statute of limitations. The Board of Tax Appeals made the following observation.

It may, however, be seriously doubted also whether, since the inclusion of future expenditures in cost has been held to be a matter of right, the Commissioner may refuse it because the taxpayer has omitted to file the waiver required by [Mim. 4027].

Because the year in question was 1931 and Mim. 4077 was not issued until 1933, the Board did not have to rule on this issue. In Haynsworth, 68 TC 703 (1977), the Tax Court reached the same conclusion, citing Cambria Development Co.

There is also the question of whether the economic performance rules apply only to expenses and not to capitalized costs. In Molsen, 85 TC 485 (1985), the court held that the "all events" test of Regs. Sec. 14.461-1(a)(2) did not apply to purchases that were taken into account in computing cost of goods sold. It may therefore be possible to argue that the economic performance test of Sec. 461(h) does not apply to capital expenditures.

If the developer does not request permission under Rev. Proc. 75-25, he must nevertheless comply with two of the conditions of Rev. Proc. 75-25. These are conditions that have been established by the courts in order to comply with the "all events" test.

1. There must be a contractual obligation. (See Haynsworth, supra; Herzog Building Corp., 44 TC 694 (1965); Memphis Memorial Park, 28 BTA 1037 (1933); Birdneck Realty Corp., 25 BTA 1084 (1932); and Mackay, 11 BTA 1155( 1928).)

2. The developer cannot recover the estimated future costs through depreciation. The courts have said this in another way, holding that the developer cannot retain title to the property. (See Noell, 66 TC 718 (1976); The Colony, Inc., 26 TC 30 (1956); and Fairfield Plaza, Inc., 39 TC 706 (1963).)

Therefore, it seems that if the two conditions are met, the developer may be able to include the estimated costs in the basis of the lots sold without complying with Rev. Proc. 75-25.

However, it should be noted that, in Letter Ruling (TAM) 8248005, the Service held that the taxpayer, who was under audit, could not retroactively apply Rev. Proc. 75-25 and thus could not include the estimated costs in the basis of the lots previously sold.

Although a position may exist for not fully complying with Rev. Proc. 75-25, such a position would likely be challenged.

From Jerry S. Williford, J.D., CPA, Houston, Tex.
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Author:Williford, Jerry S.
Publication:The Tax Adviser
Date:Feb 1, 1992
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