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Special accounting method for common area costs of real estate developers.

Consistent with both IRS rules and case law, real estate developers have historically been permitted to allocate the estimated costs of future improvements to homes or lots sold for purposes of determining gain or loss resulting from the sale of property. Under Rev. Proc. 75-25 developers were required to be contractually obligated to make the improvements; the Service also required that the developer agree to an extension of the statute of limitations (SOL) for assessing tax liability on any issue, not just the estimated costs issue. Some developers simply added estimated costs to basis without complying with the information filing requirements and without an SOL extension.

The IRS regards the deduction of estimated costs as inconsistent with the "economic performance" rules of Sec. 461(h), enacted in 1984. These rules added an additional prerequisite that must be met before an expense may be deducted; an amount is not recoverable until economic performance is met. If goods or services are provided by the taxpayer, an expense is not incurred before the time when the goods or services are provided.

Real estate developers might not undertake construction of certain common improvements until the first phases of a development are sold. For example, a developer may wait until the initial phase of a housing project is sold before beginning construction of a community swimming pool or golf course. The IRS believes that the 1984 change delays recovery of these costs until the common area costs actually are incurred.

The Service did not first publish its new position on common area costs until June 1990, when it issued proposed regulations relating to the economic performance requirement. In the preamble to those regulations, the IRS stated that it would revoke prior guidance allowing the current recovery of costs of future common area improvements, effective for tax years beginning after Dec. 31, 1989. This stance caused storms of protest by developers and home builders. As a result, in January 1991, the Service issued Notice 91-4, which preserved the prior beneficial treatment for developers and home builders if they agreed to comply with the IRS procedural requirements for this treatment (contained in Rev. Proc. 75-25).

As a final compromise, the Service has authorized use of an "alternative cost method." This new method (described in Rev. Proc. 92-29) allows some estimated future costs to be deducted.

Under the alternative cost method, a developer is permitted to recover (i.e., include in basis on sale) a property's allocable share of the estimated cost of common improvements, without regard to whether the costs are incurred under the economic performance requirement, subject to certain limitations.

A common improvement is any real property or improvement to real property that benefits two or more properties separately held for sale by a developer. Examples of common improvements include streets, sidewalks, sewer lines, playgrounds, clubhouses, tennis courts and swimming pools that developments is contractually obligated or required by law to provide.

As of the end of any tax year, the total amount of common improvement costs included in the basis of property sold may not exceed the amount of common improvement costs that have been incurred for economic performance purposes (the alternative cost limitation). If the alternative cost limitation precludes 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 may be taken into account in a subsequent tax year, to the extent additional common improvement costs have been incurred under the economic performance rules.

The alternative cost limitation is applied on a project-by-project basis. The common improvement costs incurred for one project, therefore, may not be included in the alternative cost limitation of a second project. See Examples 1 and 2 on page 223-224.


Use of the alternative cost method is conditioned on complying with certain procedural requirements. * The developer must file a request to use the alternative cost method on a project-by-project basis with the district director. The request must be filed on or before the due date (including extensions) of the developer's original tax return for the tax year in which the first property in the project is sold. Information regarding the project, common improvements, estimated costs and other matters must be included. A copy of the request should also be attached to the developer's timely filed tax return.

A supplemental request must be filed if, for a valid reason, the developer is unable to complete the common improvements within the originally anticipated time frame. * The developer must agree to extend the SOL on the assessment of income tax for each tax year in which the alternative cost method is used. The extension is for the expected duration of the project, plus one year. If the project lasts longer than expected, a new consent must be filed, extending the SOL to one year beyond the new expected completion date.

Note that the consent is limited to the assessment of deficiencies attributable to use of the method for the specific project(s) covered by the consent. * The developer must file an annual statement with the district director for each project for which it has received permission to use the alternative cost method. The statement should include information such as an update of estimated costs, a description of the manner in which estimated costs have been allocated, and the number of lots sold.

Rev. Proc. 92-29 is effective for sales of property after Dec. 31, 1992. Developers that have received explicit IRS consent for a prior more favorable position may continue to use that position (i.e., the alternative cost limitation will not apply) for sales of property after Dec. 31, 1992 that are covered by the consent. Developers may opt to apply the new rules for property sales occurring after Dec. 31, 1990 (although this normally would not be advantageous, since the prior rules were more liberal).

Although the alternative cost limitation must be applied on a project-by-project basis, the Service has Provided no definition or other guidance to assist developers in determining the scope of a project. Developers should carefully define each project to optimize the tax benefits.

Significantly, the definition of a project may also affect the amount of interest required to be capitalized under the interest capitalization rules. These rules use the term "common feature" in setting forth the rule that the production period (and therefore interest capitalization) begins for a real property unit when production is started on any common feature benefiting the unit. Because "common feature" and "common improvement" appear to be conceptually the same, an overly expansive definition of a project could unintentionally restrict the ability to narrowly define which property units are benefited by a specific common feature for interest capitalization purposes. The broad definition of a project thus could prematurely trigger the requirement to capitalize interest on the affected property.

The alternative cost method represents a limited accommodation by the IRS to the specific needs of real estate developers and home builders. Although new rules do not fully preserve the benefits of the old law, they nevertheless may result in tax benefits considerably better than under the economic performance rules alone. Developers, therefore, need to be aware of the new guidelines to ensure that procedural filing requirements essential to obtaining this preferential treatment are met and to accurately assess the impact of the rules on planned projects.
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Author:Minasian, Susan
Publication:The Tax Adviser
Date:Apr 1, 1993
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