Special accounting method for common area costs of real estate developers.

• Author: Minasian, Susan

Consistent with both IRS rules and case law, real estate developers have historically been permitted to allocate the estimated costs of future improvements to homes or lots sold for purposes of determining gain or loss resulting from the sale of property. Under Rev. Proc. 75-25 developers were required to be contractually obligated to make the improvements; the Service also required that the developer agree to an extension of the statute of limitations (SOL) for assessing tax liability on any issue, not just the estimated costs issue. Some developers simply added estimated costs to basis without complying with the information filing requirements and without an SOL extension.

The IRS regards the deduction of estimated costs as inconsistent with the "economic performance" rules of Sec. 461(h), enacted in 1984. These rules added an additional prerequisite that must be met before an expense may be deducted; an amount is not recoverable until economic performance is met. If goods or services are provided by the taxpayer, an expense is not incurred before the time when the goods or services are provided.

Real estate developers might not undertake construction of certain common improvements until the first phases of a development are sold. For example, a developer may wait until the initial phase of a housing project is sold before beginning construction of a community swimming pool or golf course. The IRS believes that the 1984 change delays recovery of these costs until the common area costs actually are incurred.

The Service did not first publish its new position on common area costs until June 1990, when it issued proposed regulations relating to the economic performance requirement. In the preamble to those regulations, the IRS stated that it would revoke prior guidance allowing the current recovery of costs of future common area improvements, effective for tax years beginning after Dec. 31, 1989. This stance caused storms of protest by developers and home builders. As a result, in January 1991, the Service issued Notice 91-4, which preserved the prior beneficial treatment for developers and home builders if they agreed to comply with the IRS procedural requirements for this treatment (contained in Rev. Proc. 75-25).

As a final compromise, the Service has authorized use of an "alternative cost method." This new method (described in Rev. Proc. 92-29) allows some estimated future costs to be deducted.

Under the alternative cost method, a...