South Florida’s condo market is booming, thanks in large part to cash-rich buyers who are willing and able to pay pricey deposits prior to and during construction. These deposits on long-term construction contracts present property developers with significant tax-planning challenges and opportunities.
Long-Term Construction Contracts (LTCCs) for the building, manufacturing, installation or construction of property that will not be completed in the same taxable year in which the contract is executed require unique methods of accounting for revenue recognition. Failure to consider all of the components associated with accurately reporting income on LTCCs and the planning opportunities for postponing tax liabilities could result in severe penalties for non-compliance as well as lost opportunity costs when developers use available capital to pay taxes.
Typically, real estate developers recognize revenue using one of two methods. Under the Completed Contracted Method, the developer generally recognizes revenue when the contract is complete and accepted by the customer. However, when developers pre-sell projects utilizing LTCCs, they may be required to use the Percentage-of-Completion Method (PCM). Unless the LTCC covers one of several exempt projects, such as single-family homes, townhouses and buildings containing four or fewer residential dwellings, the developer may recognize revenue annually, throughout the development period using PCM. This may occur despite the fact that deposits the developer received from customers, which, by law, cannot be used to pay non-construction-related expenses.
Under PCM, revenue is determined by dividing the actual contract costs incurred through the end of a specific year by the total costs that the developer expects to incur over the life of the contract. The resulting fraction is then multiplied by the unit sales price to determine cumulative revenue to be recognized. Revenue recognized in all prior taxable years is then subtracted from the current tax year’s cumulative revenue to determine the revenue to be recognized for that particular tax year.
An exception to these revenue-recognition rules occur when LTCCs involve residential buildings in which 90 percent of the expected costs of the building are allocable to dwelling units. In these instances, the developer may determine income from a residential construction contract using the Percentage-of-Completion/Capitalized-Cost Method (PCCM). The IRS allows developers of residential condos that meet this 90 percent test to calculate 70 percent of the contract revenue using the percentage of completion method while typically using the preferable completed contract method to compute the remaining 30 percent of contract income. For alternative minimum tax (AMT) purposes, the developer must calculate the entire contract under PCM. As a result, the 30 percent of contract income that the developer can defer for regular tax purposes becomes taxable for AMT purposes, which generally results in a significant adjustment to alternative minimum taxable income.
When developers are required to account for their projects using the PCM or PCCM methods, it is likely that they and their investors will recognize so-called “phantom income,” which is taxable income recognized when there is no cash available from the project to distribute to investors to pay the taxes. Understanding this and other nuances in revenue recognition requirements allows condominium developers and their investors to properly plan for and address cash flow and tax liabilities associated with allocated income or losses from a particular project. This necessitates that developers employ the most advantageous accounting and tax planning strategies while mitigating risks associated with under-reporting income.
Costs Capitalization vs. Deduction Allocation
Condominium developers may not deduct the costs of developing a project in the year they incur those costs. Instead, they must accumulate and capitalize those costs by applying them against the revenues from future unit sales.
Capitalized costs on long-term contracts include both direct costs, such as land, direct materials and direct labor; and indirect costs, which involve expenses for project oversight, executive compensation, pension and employee benefits, rent, taxes, insurance, utilities, repairs, maintenance, engineering and design. These capitalized costs are applied against the revenue recognized under the PCM or PCCM methods. Prior year cumulative costs recognized are subtracted from the cumulative costs incurred at the end of the current taxable year and the difference is applied against the revenue recognized for the year to arrive at gross profit.
Certain indirect costs, such as those incurred for sales and marketing, including commissions on unit sales, are not required to be capitalized and may therefore be deducted in the year they are incurred. Developers may deduct these costs from gross profits realized from the PCM or PCCM method to arrive at taxable income for the year.
Interest expense may be deducted or capitalized, depending on the production cycle of a particular project. Developers must capitalize these costs for the production period of each unit of real property, which begins on the first date that physical production activity related to that unit commences and ends when either (1) the building is completed, or (2) the production ceases for a period of 120 days. Production activity includes not only construction activities for a building or structure, but also the clearing and grading of raw land, the demolition of a building and the construction of infrastructure, such as roads, sewers, sidewalks and landscaping. As a result, interest is generally deductible in the early stages of a particular project when a site is acquired. As a general rule, capitalization of interest expenditures begins when a shovel is taken to the proposed site.
Look-Back Rules
Taxpayers must pay or are entitled to receive interest on the amount of tax liability that they defer or accelerate as a result of their overestimation or underestimation of total contract price or contract costs. Under this look-back method, taxpayers must pay interest for any deferral of tax liability resulting from the underestimation of the total contract price or the overestimation of total contract costs. Conversely, if the total contract price is overestimated or the total contract costs are underestimated, taxpayers are entitled to receive interest for any resulting acceleration of tax liability.
The purpose of the look-back method is to compensate either the IRS or developers for any deferral or acceleration of contract income that results from the use of estimated, rather than actual, total contract costs in applying the percentage of completion method. The look-back method is intended to offset the time-value effects of using estimates during the life of a contract that differ from the actual amounts determined upon the completion of the contract.
Understanding the revenue recognition rules and managing taxable income is not a simple task for developers of multi-family properties. It requires effective tax planning from the early stages of a project’s conception and continues through to project completion. For instance, developers who wish to meet the 90 percent test to utilize the PCCM method rather than the PCM method must address the issue during a building’s concept design phase. Additionally, developers may consider revenue deferral strategies, such as converting reservation deposits into executed contracts in January of a subsequent year, rather than in December of the current year.
Similarly, there may be tax-planning opportunities to accelerate deductions. For example, developers may consider optimizing sales-commission structures in order to accelerate deductions. Finally, the capital structure of many projects provides a particular partner (sponsor) a carried interest, which generally grants the sponsor a larger allocation of the cash distributions than his or her proportional share of the capital contributed, if any. Because income from the development and sale of condominiums is typically ordinary income, it may be more beneficial to structure the carried interest formula instead to be a development fee to be paid to the sponsor at the end of the project. As a result, the sponsor’s fee would become a cost of the project, which could potentially reduce the percent complete ratio. In turn, this could decelerate the revenue recognition for the investors. The sponsor may also be able postpone the recognition taxable income from his share of the deal profit to more closely correspond with his receipt of cash from the project.
The Real Estate Tax professionals with Berkowitz Pollack Brant have extensive experience guiding developers through the labyrinth of revenue recognition challenges and developing sound strategies to optimize tax-planning opportunities.
About the Author: Edward N. Cooper, CPA, is a director with Berkowitz Pollack Brant’s Tax Services practice. For more information, call (305) 379-7000 or e-mail info@bpbcpa.com.
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