IRS updates accounting for common improvements
The Rev. Proc. updates the accounting methods for developers to recover common improvement costs in connection with the sale of individual units in a development project. The new alternative cost method is an alternative to economic performance rules under Section 461(h). It allows the developer to include the share of estimated costs of common improvements allocable to the units sold in the basis of such units regardless of whether the costs were incurred under Section 461(h), subject to the “alternative cost limitation.”
It further introduces a new accounting method change and provides relief for proper implementation of the new requirements. Perhaps most importantly, the new Rev. Proc. mostly eliminates the overly burdensome disclosure and requirement that taxpayers agree to a 10-year statute of limitations on assessments pursuant to 92-29.
Under either an accrual method (e.g., percentage of completion) or completed contract method of accounting, the alternative cost method may be used to allocate the cost of common improvements via any method applied on a consistent basis and reasonably reflecting the benefits provided to the individual units in a particular project.
The Rev. Proc. illustrates an example whereby the estimated costs of common improvements may be allocated based on one of the following: relative cost of unit, relative size of a unit or relative fair market value of a unit. The IRS further states it may be reasonable to adopt one of the above approaches for certain common improvement costs while utilizing a different approach for other common costs if the “hybrid” allocation methodology is applied consistently.
The Rev. Proc. defines “common improvements” and provides detailed examples of what qualifies, such as streets, sidewalks and tennis courts, that the developer is contractually required to provide, that benefit two or more units and aren’t depreciable. It also defines “estimated cost of common improvements” as equal to the amount of common improvement costs incurred under Code Section 461(h) at the end of a taxable year added to the amount of common improvement costs reasonably anticipated to be incurred during the 10 succeeding taxable years.
While the estimated costs of common improvements may change from year to year, a developer may not adjust the estimated cost of common improvements for a prior taxable year following a determination that the original estimate has been either understated or overstated. Any adjustment following such a determination is allocated to all the development units and made in the determination year versus on an amended tax return or administrative adjustment request.
The annual alternative cost limitation caps the utilization of the cost of estimated common improvements for a year to the total of common improvement costs incurred under Code Section 461(h); that is, the annual allocation of these costs to unit sales in a taxable year is limited to the total costs satisfying the economic performance test under 461(h). See example #1 below.
Finally, the Rev. Proc. adds a new method change to the list of automatic accounting method changes for taxpayers adopting the revised alternative cost method; it's available for tax years beginning after Dec. 31, 2022. Taxpayers without any adjustment in the taxable year of change may use a shortened Form 3115 (Application for Change in Accounting Method), and the general rule prohibiting subsequent automatic method changes within five years isn’t applicable.
- Units: 10
- Project length: 3-YRS
- Estimated common improvement costs: $500,000.00
- Allocable share per unit: $50,000.00
- Accounting method: Accrual
- CY improvements divided by # of homes to be sold
- allocable share per unit times # of houses sold in CY
- CY allocable share per unit times Pys # of homes sold
- PY allocable share per unit times CY # of houses sold
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