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Real Estate Development-When to Expense vs Capitalize Costs

Technical topics regarding tax preparation.
#1
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Happy Monday to all!

Have a real estate developers LLC
The entity obtains a loan; buys land, & constructs
residential homes.
After the homes sell;the loans are paid off at closing.

The entity is under the $25 million gross receipts threshold.
I have in the past capitalized direct costs (WIP) until sales
& expensed interest, real estate taxes & insurance since
their receipts are under the threshold.

The Client wants to take the expenses each year as he incurs
them?? Is this method an option???

Obviously it will not be pretty when He actually sells property with
only currents costs in COGS. (he has another 2018 entity
with a large net income & is wanting to offset )

He isn't happy & I am not comfortable with this option..
Am I mistaken??

Thank you!
 

#2
JAD  
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Interesting. TCJA did not change 263. But if developer does enough of these transactions, are the houses inventory, qualifying him to elect out of 471 requirements?

The $25M test is not just at the entity level - you also have to take a look at his other businesses. https://www.aicpa.org/interestareas/tax ... rules.html
 

#3
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The dmsh does not apply where inventory is concerned. In other words it’s not an option.
 

#4
Nilodop  
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... are the houses inventory, qualifying him to elect out of 471 requirements? . I think they are
... property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business
. Else we would not need that phrase in section 1221(a)(1), after the word "or".
 

#5
Coddington  
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Terry Oraha wrote:The dmsh does not apply where inventory is concerned. In other words it’s not an option.


That's not what the JCT Blue Book said.
-Brian
Tax accounting methods and credits consultant for hire.

http://www.coddingtontax.com
 

#6
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Coddington wrote:
Terry Oraha wrote:The dmsh does not apply where inventory is concerned. In other words it’s not an option.


That's not what the JCT Blue Book said.



Are you saying that if the inventory is treated as materials and supplies then the DMSH could apply?
 

#7
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DMSH ? ?
 

#8
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De Minimis Safe Harbor.
 

#9
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ok
 

#10
Coddington  
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Terry Oraha wrote:
Coddington wrote:
Terry Oraha wrote:The dmsh does not apply where inventory is concerned. In other words it’s not an option.


That's not what the JCT Blue Book said.



Are you saying that if the inventory is treated as materials and supplies then the DMSH could apply?


Yes.
-Brian
Tax accounting methods and credits consultant for hire.

http://www.coddingtontax.com
 

#11
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Doubtful that the taxpayers aggregrate gross receipts will go over the $25million threshold..
On the balance sheet is approximately $4million land/inventory acquired in 2018..
Can't imagine expensing this additional amount on 2018 tax return when there already is a significant
loss of approx. $195K..
thoughts appreciated
 

#12
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Well apparently your asnwers are a combination of the suggestions by JAD and Brian. You change their method of accounting to treat inventory as materials and supplies (DCN 235) then apply the DMSH. To the extent DMSH applies you could arguably take an immediate deduction for some direcct costs.

In a situation like this you might want to look at change in method of not applying 263A (DCN 234) and cash method of accounting options (DCN 233). I'd consider all then figure in the best changes for your client's circumstances.

Here are some good readings:

https://www.currentfederaltaxdevelopmen ... ng-methods
viewtopic.php?f=8&t=12901
 

#13
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Thanks Terry Will read!

Just can't get my head around deducting $4 million in inventory in 2018 and then not
have any costs for 2019 when majority of houses sell in 2019...
 

#14
Wiles  
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How do you apply the DMSH election to developments costs, such as $6,000 of insurance?
 

#15
Coddington  
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I probably should have mentioned this before, but the TCJA changes, at most, take us back to pre-'86 law. Developers can't use section 471 for their "inventory", since it isn't merchandise. Since it isn't inventory under 471, they cannot elect NIMS treatment. Examples 17 and 18 of Rev Proc 2002-28 may be instructive in what is possible.
-Brian
Tax accounting methods and credits consultant for hire.

http://www.coddingtontax.com
 

#16
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Thanks Brian!
Have my homework assignment for this evening!

S
 

#17
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Coddington wrote:I probably should have mentioned this before, but the TCJA changes, at most, take us back to pre-'86 law. Developers can't use section 471 for their "inventory", since it isn't merchandise. Since it isn't inventory under 471, they cannot elect NIMS treatment. Examples 17 and 18 of Rev Proc 2002-28 may be instructive in what is possible.


That thought did cross my mind. That means that you can tell you client he can’t do it Hayden.
 

#18
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Thank you Terry!!!
 

#19
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Terry & Bryan!
Back to my original post ;
the entity IS allowed to Expense Indirect
Costs because the gross receipts are under
$25million -correct?
 

#20
Chay  
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Coddington wrote:Developers can't use section 471 for their "inventory", since it isn't merchandise. Since it isn't inventory under 471, they cannot elect NIMS treatment. Examples 17 and 18 of Rev Proc 2002-28 may be instructive in what is possible.

I'm confused by a couple of things here.

Example 17 of Rev Proc 2002-28 says "Because the house is real property held for sale by Taxpayer, the house and the material used to build the house are not inventoriable items under this revenue procedure. Thus, Taxpayer may not account for the items used to build the house as non-incidental materials and supplies under § 1.162-3." On the other hand, this article says "The most favorable impact will be to manufacturers that will now deduct the cost of purchased raw materials when the materials move out of storage into the work-in-process phase. Direct labor and direct overhead will be immediately deductible under this method. For resellers and distributors there is much less of an impact since it will be likely that their material purchases will be used or consumed when the product is sold to customers."

Is the article correct? If so, what distinguishes a real estate developer from a manufacturer? In both cases, material and labor are combined to create a finished product. Is there some rule that distinguishes real property from inventory?

If real property held for sale isn't inventory in the first place, then aren't we free to employ the DMSH just as we would with improvements made to any other type of real estate?

And finally, in the case of a house flipper or other dealer in real estate, whose product apparently isn't "inventory", how do we report the cost of the sale? Would Form 1125-A or Part III of Schedule C be used in the same way, with a beginning and ending "inventory"?
 

#21
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My understanding is that the real property is still inventory, but not merchandise. A legal definitioon for merchandises is, generally, the term merchandise is used to denote a movable object involved in trade or traffic and that is passed from hand to hand by purchase and sale.That means it is not allowed various treatments that are common to inventory that is merchandisable. Example, it cannot be subject to a write off for obslescence, treated as materials and supplies (new to me), other possible exceptions could be out there that I'm not aware of.
 

#22
Chay  
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Since posting those questions, I've stumbled on the Construction Industry Audit Technique Guide, which states that "[t]he Internal Revenue Code defines inventory as tangible personal property" (on page 99). I'm not sure where that particular rule is found, but in any case the Guide has plenty of case law support for the position that real estate cannot be inventoried. So, Terry, I think your analysis is on point, except that real estate seems not to be considered inventory at all.

But then there are the other two questions I asked. The DMSH can't be applied to "property that is or is intended to be included in inventory property", and the cost of goods sold calculation makes explicit reference to "inventories". Are we to understand the term "inventory" identically both these instances and as it applies to real estate that can't be "inventoried"? I have a feeling the answer is complex and might involve something that Coddington would refer to as a "through the looking glass" moment.
 

#23
Coddington  
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We don’t know how the DMSH will work for real property development. I’d suggest making the DMSH election on the return, making sure book expensing is in place, but not tax conformity. Amend if they approve real estate expensing, otherwise the audit risk seems too big.
-Brian
Tax accounting methods and credits consultant for hire.

http://www.coddingtontax.com
 

#24
Coddington  
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Just to follow up, under the DMSH, the section 263A coordination rule combined with the anti-abuse rule should work to eliminate the DMSH for many development activities. But what do we do when we have a developer that is no longer subject to 263A as a small taxpayer and whose invoices are already sufficiently componentized to fit under the DMSH? At that point, the DMSH result would need to be compared to completed contract and other small taxpayer construction methods. I don't think it would necessarily provide a better result.
-Brian
Tax accounting methods and credits consultant for hire.

http://www.coddingtontax.com
 

#25
Chay  
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Coddington wrote:But what do we do when we have a developer that is no longer subject to 263A as a small taxpayer and whose invoices are already sufficiently componentized to fit under the DMSH?

As it happens I do have one such client. His DMSH development costs are $40k+ after filtering them through the anti-abuse rule. There's no revenue from this business for the year, but the return itself has over half a million in AGI. We had a chat about this and he says he's fine with the audit risk and doesn't mind if the IRS expresses a "difference of opinion" as to how much tax he owes. So, we're going through with it.

If we get any pushback from the IRS, I'll post again to this thread. If not, you can assume the position has gone unchallenged.

As always, thanks Brian for your valuable insight.
 


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