Industry Insights

In this period of economic challenges, real estate operators and developers, as well as builders and construction companies, are struggling with increased competition, downward pricing pressure and limited access to credit. These factors have given rise to a host of business issues. Liquidity and cash flow are more important than ever to a company’s strategic agenda.

The recent financial crisis has created an extremely tight lending environment affecting companies across all industries. Companies are experiencing restricted credit terms and noncompliance of loan covenants. In some instances, available credit has all but disappeared. Now, more than in any time in recent history, prudent cash management is essential.

Below are a few ideas that can be cash generators for real estate and construction companies.

Tax Planning

Change in Accounting Methods

Regardless of a company’s financial and operating status, tax planning can provide a variety of strategies to help companies preserve, acquire or maximize cash. Some companies are beginning to examine accounting method changes that defer income recognition or accelerate deductions to create cash benefits that reduce current tax expense and increase cash flow.

By implementing an accounting method change, taxpayers not only receive prospective benefits from the deferral of future income recognition or acceleration of deductions, but also generally are required to adjust prior tax years under Internal Revenue Code (IRC) Sec. 481(a) to ensure there are no omissions or duplications in changing the accounting method. In other words, the 481(a) adjustment serves as a catch-up adjustment for prior years and can have a significant impact on a company’s current year tax liability, because a favorable catch-up adjustment is generally included entirely in the year of change.

What to Look For & Why Opportunities Have Been Missed

Given the broad scope of accounting method issues, deciding which tax methods and opportunities to consider can be difficult. A review of specific construction contracts, real estate and capital improvement contracts, insurance policies, lease agreements, financial statements and tax returns can identify numerous tax savings opportunities.

Implementing an Accounting Method Change – Procedural & Practical Considerations

Methods of Accounting & Method Changes – Brief Overview

An accounting method encompasses not only the taxpayer’s overall method of accounting, but also the accounting treatment of any income or expense item. For taxpayers following financial statement reporting methods of accounting for various taxable income or expense items, there can be significant opportunities to review and change tax accounting methods. The statutes require taxpayers seeking to change their accounting method for tax purposes to obtain the commissioner’s consent, usually by filing a Form 3115, Application for Change in Accounting Method, during the taxable year in which the taxpayer desires to make the proposed change.

Common Accounting Method Changes

Timing of Income Recognition

To the extent the taxpayer has income, the key consideration becomes the proper time to recognize the amount for tax purposes. In general, under the accrual method of accounting, income is includible when all the events have occurred that fix the right to receive such income and the amount can be determined with reasonable accuracy.

Timing of Expense Recognition

Expenses

Generally, an accrual basis taxpayer recognizes an expense item for federal income tax purposes when all of the events have occurred that fix the fact of the liability, the amount of the liability can be determined with reasonable accuracy and economic performance has occurred with respect to the liability. Taxpayers must be aware of these issues to effectively employ favorable accounting methods and ensure current methods are permissible for expense recognition. Some of the more common expense items that may necessitate an accounting method change are described below.

Taxes

Many taxpayers deduct tax expense in the year in which the tax expense is paid. Although this is consistent with the economic performance rules, there is an opportunity to accelerate the deduction for certain taxes. Taxpayers generally recognize the liability of real property taxes, personal property taxes, state income taxes and state franchise taxes in the taxable year in which the taxes are paid. However, there is an opportunity for these taxpayers to implement a method change, under the automatic consent procedures, that would accelerate the deduction to the year the tax assessment is made, so long as the taxes are paid within 8 1/2 months of the end of the year or by the time the tax return is filed, if that occurs earlier.

Prepaid Expenses

Companies required to prepay certain expenses may be able to take a current deduction for these expenses rather than capitalizing and amortizing the amounts over the term of the underlying agreement or only taking a deduction at the time services are rendered. In particular, taxpayers are not required to capitalize amounts paid to create certain rights or benefits with brief duration. This is commonly referred to as the 12-month rule, which says taxpayers may make an automatic method change and take a current deduction for certain expenses, such as prepaid insurance premiums and operating licenses.

Taxpayers also may take a current deduction for amounts paid in advance of specific services being performed, so long as the taxpayer can reasonably expect the services or property to be provided within 3 1/2 months of the payment. Common expenses for which this may apply include prepaid postage, prepaid advertising, prepaid commissions and short-term service contracts. A method change to accelerate the deduction of these prepayments requires advance consent.

Bad Debts

In this difficult economy, many taxpayers have customers or clients unable to pay outstanding balances. In these instances, a taxpayer could take a deduction for a debt that becomes worthless within the taxable year. A taxpayer currently deducting the financial statement reserve for tax purposes may receive the automatic consent to change accounting methods from a reserve method to a specific charge-off method that complies with IRC Sec 166. To the extent a debt becomes partially worthless within the taxable year, a taxpayer may, but is not required to, take a deduction for such debt. If the taxpayer already is using the specific charge-off method for wholly worthless bad debts, it is not a change in accounting method to charge off partially worthless bad debts. Determining whether a debt has become worthless is driven by facts and circumstances and requires careful review.

Cost Segregation Study

Many real estate operators can receive significant tax benefits through an engineering-based cost segregation study examining the company’s fixed assets and implementing an automatic method change to reclassify fixed assets to a shorter recovery period or to catch up missed depreciation, such as bonus depreciation, resulting in accelerated tax depreciation. This acceleration is further enhanced by the pending extension of the 50 percent additional first-year bonus depreciation rules for certain shorter-lived property. This is an automatic method change per Sec. 481(a), and taxpayers can take the adjustment over a one-taxable-year period as specified by Rev. Proc. 2002-9 and modified in Rev. Proc. 2002-19.

Although accounting method issues are often overlooked or dismissed as insignificant, companies cannot afford to ignore these “timing issues” in today’s economic environment. A close analysis of these basic income and expense timing items may result in significant bottom-line benefits through deduction accelerations or income deferral.

Before making any accounting change, consult your BKD tax advisor.