Capitalization versus expense of interest and real estate taxes is a balancing act for real estate developers of residential building lots.
A real estate developer acquires a tract of vacant, undeveloped land with borrowed funds or contributed capital for the sole purpose of utilizing a sub-contractor to sub-divide and develop the land into lots or parcels for ultimate sale, primarily as residential building lots.
As you can see by the discussion below, there are timing differences between reporting interest and real estate taxes for GAAP (book) financial reporting purposes and tax reporting purposes. However, as discussed below, the overall book results and overall tax results (profit or loss) is balanced out at the termination of the project.
The Internal Revenue Service should not have any issue with the up-front tax deduction of real estate taxes and interest since it all is balancing out at the end, as discussed below.
The sub-contractor performs site balancing (grading, excavating, etc.) to develop the lots for sale to customers. The period during which the real estate is being developed is commonly called the production period or development stage.
Real estate taxes incurred during the production period are required to be capitalized under the UNICAP Rules (Code Sec 263A). Without regard to the production period, a real estate developer must, under Code Section 263A, capitalize real estate taxes even if no development takes place.
Development of real property for a subdivision for purposes of capitalized real estate taxes takes place, and therefore, the property is produced when the developer takes the initial steps in the development process, which is commonly referred to as the pre-development stage and includes the following:
- Obtain building permits
- Perform engineering and feasibility studies
- Prepare architectural plans
- Legal expenses incurred to mitigate adverse conditions
The above costs are commonly referred to as soft costs, while the physical development or site balancing costs are commonly referred to as hard costs.
Subsection 263A (F) specifies that only interest incurred during the production period is capitalized. However, the definition of production period for interest capitalization purposes is markedly different from the definition of production period for real estate taxes capitalization. For development of subdivision lots, the production period for interest capitalization begins when physical activity (site balancing, excavating etc.) is performed on the vacant land during the development stage. The physical activity performed would also include common features such as roads, water lines, parks, recreational facilities, etc.
Presumably, interest incurred on construction borrowings could be deducted as an expense for income tax purposes during the entire pre-development stage, when only land is acquired and soft costs are incurred.
The allocation of interest incurred to produce subdivided residential building lots must be done using the Avoided Cost Method. This method requires the real estate developer to first capitalize interest on debt directly attributable to construction expenses (traced debt). If construction costs exceed the traced debt then interest on indirect debt, if any, must be capitalized to the extent of the excess construction costs.
The GAAP rules for capitalized interest and real estate taxes are quite specific. Interest and real estate taxes for book and financial reporting purposes are capitalized from the inception of the project through the time the residential building lots are ready for their intended use. Once the production period is completed, real estate taxes and interest are deducted as an expense for book (GAAP) purposes in what is commonly referred to as the post-development stage. This method for capitalization and expense is typically used by real estate developers of residential subdivision building lots, regardless of any required financial reporting requirements.
It would then seem logical that for income tax reporting purposes, the real estate developer would also expense real estate taxes and interest during the post-development stage.
It should be noted that both interest charges and real estate taxes paid by the developer, when the vacant land is acquired, must be capitalized for income tax reporting purposes.
Let’s step back and review the requirements for capitalization of interest and real estate taxes as follows:
- For GAAP (book) financial reporting purposes:
- Interest and real taxes are capitalized from inception of the project until the residential building lots are ready for their intended use and sale.
- For income tax reporting purposes:
- Real estate taxes are capitalized from inception of the project (land acquisition) to completion of the development stage whereby the residential building lots are ready for their intended use and sale.
- Interest charges are capitalized from the start of the physical development stage of the project (hard costs) until completion of the development stage whereby the residential building lots are ready for their intended use and sale.
- Real estate taxes and interest charges are capitalized in conjunction with the developer’s initial purchase of vacant undeveloped land.
- For both GAAP (book) and tax reporting purposes, real estate taxes and interest charges during all other intervening periods from inception of the project through completion, when all of the residential building lots are developed and sold, are deducted as an expense.
Real estate developers are sometimes confronted with a period of time whereby the development stage cannot be started, primarily due to the following adverse conditions:
- Hazardous materials present
- Wetlands area
- Endangered species present on undeveloped land
- Adverse economic conditions.
Sometimes the non-productive period could last for several years, at a considerable legal cost to the developer. Usually, the above matters are ultimately resolved and the construction phase or development stage can start.
We already are aware of the fact that interest charges during the period, where an adverse condition exists and may exist for several years, are expensed for tax reporting purposes, since no physical development of the vacant land has begun.
But what about real estate taxes incurred during an extended period of time, where an adverse condition exists and development of the vacant land is on hold until the issues are resolved?
The IRS is quite clear about this issue in their rulings on the matter. A real estate developer, who purchased unimproved land for development, into subdivided residential building lots but held off on the start of development activities due to an adverse condition related to the property, still was required to capitalize the real estate taxes.
The real estate developer would have to establish non-development intent, or purpose for which the vacant land was acquired, such as being held for investment purposes.
If the real estate remains unimproved and unproductive for an extended period of time, due to adverse conditions, consideration should still be given to deducting as an expense the real estate taxes if substantial for tax purposes during that adverse period, even though the IRS has taken the position that the real estate taxes should be capitalized during a period of adverse conditions. The real estate is unimproved, so why capitalize real estate taxes during that period? Consideration should be given to preparing a disclosure statement with the tax return indicating the position taken regarding the deduction of real estate taxes for income tax reporting purposes during the period of adverse conditions.
The character of the profit from the sale of the subdivided residential building lots is all ordinary taxable income. Real estate taxes and interest charges are capitalized for GAAP (book) purposes through completion of this project, but deducted as an expense as allowed for income tax reporting purposes during certain intervening periods. This creates a timing difference between book and tax reporting, whereby the developer obtains ordinary deductions for interest and real estate taxes up front for tax reporting purposes, but not for book purposes. The overall ordinary income or possible loss on the project for book and tax is exactly the same. The only difference is the timing of the income and deductions for the project.
Let’s take a look at a real estate developer of subdivided residential building lots, who typically is a pass through type entity. Presume that in January 2015, AB developer, who files a calendar year tax return, intends to subdivide a parcel of vacant land located in New York State into 100 residential building lots and sell these lots in January 2016. The developer incurred soft costs (permits, engineering and architectural plans, etc.), from January 2015 to August 2015, to start the production period for real estate tax capitalization.
In June 2015, the New York State Department of Environmental Conservation informed AB Developer that several Henslow’s sparrows, which are an endangered species, were nesting on their vacant and undeveloped real estate. AB Developer was not aware of this adverse condition and could not obtain permits to develop the real estate. AB Developer commenced legal proceedings to obtain approval to develop the land because the Henslow’s sparrows apparently flew the coop.
In August 2015, a negotiated settlement agreement was reached with the DEC, and the necessary permits were obtained to develop the real estate.
In September 2015, the developer started the development stage hard costs of the project, whereby physical excavating, grading and other construction costs were incurred to sub-divide the land into 100 residential lots.
The acquisition of the land and all costs incurred in 2015 were financed with bank loans. The development stage was completed in December 2015, and all lots were sold in bulk to a large homebuilder in January 2016.
- Real estate taxes were deducted as an expense for tax purposes in 2015 during the adverse period, when the land could not be improved due to the bird problem.
- Interest on borrowing was deducted as an expense for tax purposes in 2015 from the start of the project in 2015 to the period just before the beginning of the development stage.
The tax deduction for real estate taxes during the adverse period ultimately is offset by additional income reported when the developed lots are sold.
The real estate developer could also go in a different direction and elect to capitalize interest and real estate taxes when the land is in the unimproved and unproductive stage. A simple election form is filed with the tax return annually.
As you can see by the above example, the GAAP (Book) and tax results for the project are exactly the same except for the timing of the ordinary income and deductions. These differences could be significant for a large real estate development project that takes several years to complete.
The concept of pay me now or pay me later enters into the decision as to how aggressive the real estate developer is when it comes to deducting interest and real estate taxes for tax purposes during the duration of the project. Cash flow requirements, etc. may necessitate front-loading the deductions in lieu of capitalizing these costs.
Michael T Vanderwerf is senior counsel based out of our Batavia, NY office.
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.