By Ryan B. Paul, CPA
Real estate developers with multiple units may want to consider a new streamlined process for capturing the estimated costs of common improvements in the units’ tax basis. A new IRS Revenue Ruling from the end of January 2023 outlines guidance for a more simplified process of electing alternative cost accounting.
New IRS guidance defines when to use alternative cost accounting and how to allocate estimated costs for common improvements. It also includes several examples to help developers properly apply the standard to qualifying projects.
The updated rule for alternative cost accounting took effect on January 1, 2023.
Background on Cost Accounting for Real Estate
Since 1992, developers have not been permitted to add common improvement costs to the units’ cost basis until the costs are actually incurred, except when electing the alternative cost method. The alternative cost method of accounting allows real estate developers to include the estimated costs of future common improvements in the tax basis when units are sold, regardless of whether the improvements have been made in the current tax year.
Common improvement costs can be allocated to the tax basis of units if the improvements are made with the primary purpose of selling the units and if the developer has minimal control or ownership over the improvements.
Qualifying for the alternative cost method has involved extra filing and reporting requirements, including submitting a request for every project by a certain timeframe, along with detailed information about the developer, project, and improvement costs. Developers would also need to agree to a longer statute of limitations for IRS assessments and submit annual statements to the IRS.
The extra filing and reporting requirements have made electing into the alternative cost method accounting method too difficult and time-consuming for many developers.
Updated Accounting Method Guidance for 2023
In new guidance that became effective at the beginning of 2023, real estate developers can now use one simplified form – a shortened Form 3115, Application for Change in Accounting Method – to elect alternative cost accounting for all qualified projects.
Developers must use an overall accrual method of accounting and be contractually obligated to provide common improvements to a qualifying project. Common improvements are defined as “any real property or improvements to real property that benefit two or more units that are separately held for sale by a developer.” In addition to contractual obligations to make the improvements, developers cannot also reclaim such costs through depreciation.
According to the Revenue Procedure, examples of common improvements are:
- Sewer lines
- Tennis courts
- Swimming pools
Common improvement costs do not include property maintenance or repair costs, construction period interest, or property taxes.
Developers have some latitude when applying the estimated cost of common improvements to qualifying units or contracts. The approach must be consistent and reflect the benefit provided to the units in a particular project.
“For example, a pro rata allocation of the estimated cost of common improvements or an allocation of the estimated cost of common improvements based on the relative costs to be incurred for the benefitted unit, on the relative size of the benefitted unit, or on the relative fair market value of the benefitted unit may be reasonable.”
Developers have up to ten years to incur estimated common improvement costs, and they can make changes to cost allocations each year if needed. They cannot, however, make changes to costs in a prior year even if the actual costs were greater or less than the estimates. Any such adjustments would need to be made after the original tax return is filed for that year. Total estimated common improvement costs cannot be more than the total costs incurred.
Finally, even if a developer put in a request for the accounting method change on a specific item within the last five years, they are still eligible to include that item in the streamlined form.
Previous guidance required developers to submit paperwork for each project in their portfolio – a burdensome requirement, but one that could be useful if the developer wanted to pick and choose specific projects to apply the alternative cost accounting method. Moving forward, the simplified form will apply to all projects in a portfolio.
The benefit of the new streamlined approach would be realized on projects where common improvement costs are planned and contractually obligated over many years (up to ten). Electing alternative cost accounting would spread out the improvement costs and taxable gains over the project’s entire lifespan.
It could make more sense to keep the standard accrual method if most projects expect to incur common improvement costs in the first year. Real estate developers will need to consider the pros and cons of each approach and calculate the tax impact of both scenarios.