Deep Thoughts on Common Improvement Cost Strategies in 2023

• March 22, 2023
• Brian Duren

In our earlier post discussing tax planning strategies using the Alternative Cost Method (ACM), newly revised by the IRS in Rev. Proc. 2023-9, we observed how future costs of real estate development common improvements (which have not yet been incurred) could be permitted as a deduction against current real estate sales revenue. In this installment we further explore the ACM and add some key observations on how to appropriately apply this new method.

This guidance applies specifically to “common improvements” made in connection with a larger master development plan, the costs of which are expected to be incurred within ten years, and for which the developer will retain little to no ownership. In other words, the developed property must be produced for resale rather than held for business or investment use. A common improvement of sewer and water systems would be the typical type of common improvement cost covered by the ACM. The ten-year horizon is a rolling one. So, at inception, costs expected in years 1-10 are considered, while in year two, costs in years 2 -11 are counted. In addition to a change in the rolling years, the specific types of common improvements required to be made may change over time, along with their expected costs. 

All of this leads to a fluid calculation throughout the project’s life. As cost estimates change over time, they would be considered as those changes become known. When an expected future cost changes, all basis amounts are recalculated and reallocated to specific parcels within the development, including parcels sold in prior years. Basis adjustments, including those related to past sales, are made in the current year. As a result, a budget increase of expected future costs, made in Year 2, will result in a catch-up deduction taken in Year 2 related to the increased costs allocated to parcels sold in Year 1.

Under 2023-9, a developer allocates the total estimated costs of common improvements to all benefitted parcels using any consistently applied method which reasonably reflects the benefits provided to each property unit. Reasonable methods may include, but are not limited to, the following examples of costing allocations:

• Allocations based on the relative fair market values of each parcel at the completion of the project
• Allocations based on the relative expected costs to be incurred for each parcel
• Allocations based on the relative size or square footage of each parcel
• Allocations based pro-rata on the total number of parcels being developed

This offers the developer considerable flexibility. It will normally be in the taxpayer’s best interest to carefully evaluate their expected common improvement costs and choose a method that will allocate the highest amount of the cost to parcels which are expected to be the earliest to sell. This will result in the highest basis allocations (and lowest taxable profit) to the sales occurring earliest. 

Unlike its predecessor, the revised ACM rules apply to all projects in a “trade or business” instead of the project-by-project basis of the now obsolete rules of Rev. Proc. 92-29. While this provision is generally taxpayer-favorable, it does suggest that multiple development projects occurring under a single umbrella may need to consistently follow the ACM. As a result, in addition to defining eligible development projects for adopting the ACM, taxpayers must also define the trade or business to which the ACM applies. A “trade or business” may include multiple projects occurring on contiguous tracts of real estate, developed as part of a comprehensive master site plan, or which are marketed using a common brand. Furthermore, the cost limitation is determined on a project-by-project basis, so common costs of one project cannot be used in the calculation of a different project, even if both projects are carried on in the same trade or business. There is no guidance, however, on exactly how taxpayers define projects, or trades or businesses. Historically, general tax principles have permitted taxpayers from carrying on multiple trades or businesses within a single reporting entity, and it seems the adoption of the ACM will create more scrutiny around how the taxpayer defines its trade or business activities.

It may be fair to say that many small real estate developments do not give enough attention to common improvement expenditures, cost allocation choices, or the sales cycle over the life of the development. A transition to the new ACM offers developers a chance to revisit past practices which could allow additional costs to be associated to properties already sold, or soon to be sold, creating favorable tax benefits. This type of gift from the IRS does not come along often, and for developments with several years left to run, it could be a key tax planning strategy.

Thanks again to Perry McGowan for his contributions to this topic.

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