To capitalize or to deduct property development costs?
Land and real estate developers, regardless of size, are faced with tax issues that can have a significant impact on their resources and profits. Some of these issues relate to tracking and capitalizing property development costs. It is important for any real estate developer to be familiar with basic tax concepts regarding capitalization, in order to ensure they are following the required tax rules and are not taking deductions for costs that should be capitalized.
Brokers that acquire real estate with the intent to resell it in a short period of time as well as developers that acquire real estate with the intent to build, improve or develop the property can incur costs that may not be deductible in the current period. Such costs will be recouped either through depreciation deductions over time or recovered upon sale by increasing the cost basis of the property.
What types of costs are subject to capitalization?
Costs incurred to produce the property are not currently deductible. Taxpayers must capitalize all the direct costs of producing the property and the real property’s allocatable share of indirect costs. “Production costs” include the cost to construct, build, develop or improve real property. Processes such as grading and clearing of land, excavating for the purpose of roads, laying foundation or lines for utilities, plumbing and/or electrical work, qualify as production costs. Labor costs such as standard wages, overtime, employee benefits or payroll taxes are also included in direct costs. All indirect costs allocatable to the construction activities, such as rent, repairs and maintenance, insurance utilities and depreciation, should be capitalized as well.
There are costs a developer may incur in the pre-production phase that are also subject to capitalization, if it is more than likely the property will be subsequently developed. Some of these costs include property taxes, government permits, zoning variances or engineering and feasibility studies.
Marketing, selling and advertising costs, although very important to the sale of the property, are not considered construction related costs and can be expensed in the year incurred.
Internal Revenue Service (IRS) regulations may also require the capitalization of interest on debt incurred with respect to a property during the production period. The production period is considered to begin on the first day that any physical production activity is performed (i.e. clearing, grading, demolition, etc.). Production ends when the property is ready to be placed in service or is ready for sale. Completion date can be a problematic subject for those involved in the construction of multi-unit buildings. From a tax perspective, each unit is considered to be independent of others as long as each unit is not contingent on another in order to be sold or placed in service. Capitalized costs, in this case, must be allocated to particular units using some reasonable method accepted by the IRS.
There are other considerations that brokers or real estate developers should take into account before investing. Knowledge of the capitalization rules and regulations should be a priority for companies as these rules affect the timing of deductions with regards to income taxation.
Article provided by Anca Stradley, MKS&H.
About: McLean, Koehler, Sparks & Hammond (MKS&H) is a professional service firm with offices in Hunt Valley and Frederick, Maryland. MKS&H helps owners and organizational leaders become more successful by advising them regarding their financial, technology and management needs. Please visit www.MKSH.com for more information.