Time to Review Your Development Costing Methods

• February 17, 2023
• Brian Duren

For real estate owners engaged in long-term development projects, a key tax planning strategy is to match development costs, future costs in particular, with early-stage development revenues.

The IRS has recently revised and restated the Alternative Cost Method (“ACM”) for taxable years beginning after December 31, 2022. This is a method of accounting used to supplement traditional cost basis computations, allowing taxpayers to include in their tax basis of development property sold certain expected (but not yet incurred) future costs. The new guidance in Rev. Proc. 2023-9 has repealed Rev. Proc. 92-29 (including for previously approved projects using that method) and allows accrual method taxpayers both a replacement approach to accelerating future costs and an automatic procedure for transitioning to the new method in 2023.

Suppose you are developing a project with ten lots, homes, industrial sites, or something similar. In Year 1, you incurred $1,000,000 of common improvement costs with $100,000 allocable equally to each of the ten parcels, and you expect to incur another $3,000,000 of common improvements in the future, also allocable equally to all ten parcels. You are legally required to expend this $3,000,000 in future common improvements (such as roads, utilities, and other infrastructure or amenities) that will benefit all parcels equally. These future costs will eventually add $300,000 of additional allocable cost to each parcel, but these costs are not added to tax basis until they are “incurred” under general tax principles. The mere expectation of a future obligation does not give you tax basis today.

Assume parcels 1 and 2 are sold in Year 1. Normally, general tax principles require all revenue to be recognized when realized, but only allow a deduction for the $100,000 of common costs that have already been incurred and are allocable to each parcel, 1 and 2.  Thanks to the ACM, the taxpayer can also include the estimated future costs of $300,000 in the basis of parcels 1 and 2 sold, subject to certain limitations. Without the use of this method, the additional deductions of $600,000 in future costs allocable to parcels 1 and 2 are not allowed until the future year(s) when those costs are incurred. This may be many years after the related revenue has been recognized.

All real estate developers with projects in process on and after December 31, 2022, having common improvement costs, will want to review this new guidance, including developers following the now obsolete rules of Rev. Proc. 92-29. There is an automatic method change to adopt the new ACM, with the most flexible method change rules only for the 2023 tax year. There may be risks, and less flexibility, for those adopting the change in later years.

This ACM is used by developers who have obligations for future common costs of development parcels, so it will impact only some of the projects undertaken by the project owners, but the taxable income implications are sizable when these rules are utilized. Since this method is only available to accrual method taxpayers, cash method taxpayers may want to consider a change to the accrual method to qualify for these new rules.

We will continue to unpack this new guidance and the opportunities it provides in future posts. Huge thanks to Perry McGowan for his contributions to this article.

Tags: IRS, Real Estate, Federal and state taxation, including proposed regulations, Industry best practices, Industry trends/analysis, Year-end tax planning | Comments Off on Time to Review Your Development Costing Methods