With the release of Revenue Procedure (Rev. Proc.) 2023-9 on January 27, 2023, the IRS has simplified the process for real estate developers that incur common improvement costs to switch to the Alternative Cost Method of accounting. This change, which goes into effect for tax years beginning on or after January 1, 2023, could provide significant benefits to developers looking for opportunities amidst the ongoing challenges of inflation, labor shortages and other industry changes.
What Is the Alternative Cost Method (and Why Should You Consider It)?
Rev. Proc. 92-29 from 1992 first introduced the Alternative Cost Method of accounting, allowing developers to estimate the costs of common improvements before they were incurred and include them in the basis of the units sold. Applying this accounting method speeds up the recognition of project costs for certain developers, helping to spread the common improvement costs throughout the project’s duration instead of being primarily recognized on the back-end of the project.
Unfortunately, the process to do so under Rev. Proc. 92-29 was administratively burdensome for taxpayers. It also required developers to extend their statute of limitation for the IRS to assess any additional tax liability from the application of this alternative method. As such, while changing to the Alternative Cost Method of accounting may have been beneficial, the reality was it often was not ideal from an implementation perspective.
This new guidance from the IRS allows developers to include the estimated amount of future common improvement costs in the basis of each unit sold during the tax year, regardless of whether the costs have been incurred, and does so in a much more efficient way.
What are the Requirements to Use the Alternative Cost Method of Accounting?
Under Rev. Proc. 2023-9, as a developer you may qualify for the Alternative Cost Method if you:
- Build to sell units,
- Use the accrual method of accounting,
- Use the Completed Contract Method of accounting, and
- Are contractually obligated or required by law to provide common improvements as part of a qualifying project.
For your expenditures to be considered common improvement costs:
- Your costs must impact any real property, or improvements to the real property, that benefit two or more units separately held for sale by your company,
- You must be contractually obligated to provide these improvements to the qualifying project, and
- You cannot recover the costs of these improvements through depreciation.
Examples of common improvement costs include streets, sidewalks, sewer lines, playgrounds, clubhouses, tennis courts and swimming pools.
Note: The Alternative Cost Method must be applied to all qualifying projects in your trade or business and not on a per-project basis.
How Do Developers Apply the Alternative Cost Method?
Estimated costs of common improvements include:
- All costs incurred under Sec. 461(h), which include expenses for all events that have occurred that fix the liability within reasonable accuracy at the end of the tax year; plus
- The amount of common improvement costs you anticipate you will incur in the 10 succeeding tax years.
The Rev. Proc. does not define a specific method to estimate future common improvement costs, as it allows for any method that is a reasonable reflection of the benefits provided to the units as long as you apply the method consistently across the project. The estimate of common improvement costs may change from year to year for a variety of reasons, but when the estimated improvement cost total changes, the correction is recognized in the year of determination. You do not need to amend prior years’ tax returns nor do you have to file an administrative adjustment request.
Note that the Alternative Cost Method does limit estimated improvement costs you can deduct in a given year. The sum of the estimated common improvement costs included in the basis of all units sold through the end of the tax year cannot exceed the total costs incurred under the all-events test of Sec. 461(h) through the end of the tax year. If your estimated improvement costs exceed the total costs incurred for the project under Sec. 461(h), you will carry forward the excess estimated costs and deduct them in a subsequent tax year when additional improvement costs have been incurred under Sec. 461(h). This limitation is applied on a project-by-project basis.
If you qualify and want to apply the Alternative Cost Method to your trade or business, you can file a Form 3115 and apply for an Automatic Change in Accounting under Sec. 481 for the tax year in which you will reflect a change to the Alternative Cost Method of accounting.
Contact Becky Simmons at firstname.lastname@example.org, Jenny Tapia at email@example.com or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.