Derek Smith

Common real estate improvements include playgrounds, clubhouses, swimming pools, streets, sidewalks and sewer lines. The improvements may require a permit from the city or county or may be an incentive the developer includes to raise property values. In either case, the improvements are costs to the developer that must be allocated to the property.

Under the tax law, common improvements must benefit two or more properties separately held for sale. The improvements cannot be depreciable by the developer, and the developer must be contractually or legally obligated to make the improvements.

Consider a 10-lot subdivision for which the developer is contracted to build a clubhouse, swimming pool and playground costing $250,000, or $25,000 per lot. The developer sells two lots and incurs $50,000 on the clubhouse in Year 1. The developer can reduce the gain on the two lots sold in Year 1 by $10,000—$50,000 divided by 10 total lots, multiplied by the two lots sold.

Why can't the developer deduct $50,000 in Year 1? To deduct improvement costs for a development, the costs must meet the all-events test and economic performance must occur. Economic performance occurs as real property improvements are incurred for the benefit of the underlying property. In our subdivision example, the developer incurred only $50,000 of the estimated $250,000 cost for the improvements. As the costs incurred are spread among all the lots, the gain is only reduced by $10,000 instead of $50,000.

Projects similar to our example can be managed through tax planning to defer gain and increase project cash flow. The IRS provides a procedure where the developer can use an alternative method to allocate common costs. The alternative method allows the developer to consider estimated costs to complete the common improvements. This helps defer gain on the early lot sales, thus improving cash flow by reducing tax payments on early sales. The procedure is automatic if the developer meets certain criteria. Keep in mind there is an overall limitation based on the actual costs incurred.

In our previous scenario, the developer has 10 lots and contracts to build common improvements totaling $250,000. The developer applies for and receives approval to use the alternative cost method. In Year 1, the developer sells two lots and incurs $50,000 on the improvements. Without the consent to use the alternative cost method, the developer’s gain on the sale of the two lots was reduced by only $10,000—$50,000 divided by 10 total lots, multiplied by the two lots sold. With the alternative cost method, however, the developer can deduct $50,000— $250,000 divided by the 10 lots, multiplied by the two lots sold.

As you weigh potential investments in real estate, contact your BKD advisor to determine how common improvement costs can help enhance the value of your deal.