Including common improvement costs in real property basis

Editor: Christine M. Turgeon, CPA

A taxpayer’s adjusted basis in property for purposes of determining gain or loss from the property’s sale or disposition generally is determined under Sec. 1012, with adjustments to basis provided in Sec. 1016. Sec. 1012 provides that the basis of property is generally its cost. Sec. 1016 and Regs. Sec. 1.1016-2(a) provide that the cost or other basis of property is adjusted for any expenditure properly chargeable to a capital account, including the cost of improvements and betterments made to the property.

Real estate developers often are required by law to develop common improvements such as streets, sidewalks, sewer lines, playgrounds, clubhouses, tennis courts, and swimming pools that benefit more than one property held for sale by the taxpayer. A developer may allocate the costs of certain common improvements to the bases of lots held for sale “[i] f an analysis of the common improvement indicates that (1) the basic purpose of the taxpayer in constructing the common improvement is to induce sales of the lots and (2) the taxpayer does not retain too much ownership and control of the common improvement” (Norwest Corp., 111 T.C. 105, 134–35 (1998)).

Under general tax principles, developers cannot add common improvement costs to the basis of the benefited units until the costs are incurred under Sec. 461. As a result, if a developer sells a property before completing all the common improvements, the cost of the property would not reflect an allocable share of common improvements. The IRS recently released Rev. Proc. 2023-9, which provides guidance “for real estate developers … to determine when common improvement costs may be included in the basis of individual units of real property … held for sale.”

Prior guidance

Rev. Proc. 92-29 previously provided the procedures for a developer of real estate to obtain IRS consent to use an alternative cost method (ACM) as a safe harbor for determining when common improvement costs may be included in the basis of properties sold for purposes of determining the gain or loss resulting from the sales. Under the ACM, an allocable share of the estimated cost of certain common improvements may be included in the basis of properties sold, notwithstanding the requirements of Sec. 461(h).

However, the ACM imposes an alternative cost limitation (ACL), which limits the total amount of common improvement costs included in the basis of properties sold to the amount of common improvement costs that have been incurred under Sec. 461(h). Costs not included due to the ACL may be considered in a subsequent tax year to the extent incurred under Sec. 461(h). The ACM and ACL were applied on a project-by-project basis.

Administrative requirements

Due to the IRS’s concerns of potential taxpayer abuse of the ACM, Rev. Proc. 92-29 required taxpayers to:

• Request the IRS district director’s consent to elect to use the ACM on a project-by-project basis on or before the extended due date of the developer’s tax return by providing detailed information about the developer, the project, and the common improvement cost calculations under the ACM;
• Sign a consent extending the statutory period of limitation for assessing any tax deficiency arising from the use of the ACM on a project-byproject basis;
• File an annual statement, including detailed information about the developer, the project, and updates to the common improvement cost calculations under the ACM, for each project for which the ACM was used; and
• File a supplemental request for consent to extend the period to use the ACM and agree to extend the statutory period of limitation if a project could not be completed in the original estimated completion period.

Updated guidance

To reduce the administrative, record-keeping, and compliance burdens placed on taxpayers and the IRS, the Service released Rev. Proc. 2023-9, which is effective for tax years beginning after Dec. 31, 2022.

The ACM now is treated as a method of accounting under Sec. 446 that applies to all qualifying projects in a trade or business, as opposed to an election on a project-by-project basis. Accordingly, a change to use the new ACM is considered a change in method under Secs. 446 and 481, which will require affected real estate developers to file an accounting method change. Thus, Rev. Proc. 2023-9 provides the procedures for ACM-related method changes and modifies Rev. Proc. 2022-14 to add Section 20.14 to the list of automatic change procedures.

Taxpayers that meet certain scope requirements may file a short Form 3115, Application for Change in Accounting Method, in lieu of a standard one. Additionally, the eligibility rule in Section 5.01(1)(f) of Rev. Proc. 2015-13 — which restricts taxpayers from using the automatic change procedures if they filed an accounting method change for the same item in the last five tax years — is waived for changes to the new ACM under Section 20.14 of Rev. Proc. 2022-14, for the taxpayer’s first tax year beginning after Dec. 31, 2022.

Rev. Proc. 2023-9 also provides guidance on (1) how to apply the ACM for developers using an accrual method of accounting and completed-contract method (CCM) of accounting; (2) how to allocate the estimated cost of common improvements across benefited units in a qualifying project; and (3) how to calculate the ACL, which, unlike the ACM overall, still must be applied on a project-by-project basis (see §§3.01 and 5.04(2) of the revenue procedure). Additionally, under Rev. Proc. 2023-9, taxpayers no longer are required to provide detailed information with respect to the initial election, file annual statements for each project, or extend the statutory period of limitation.

Calculating the ACM under Rev. Proc. 2023-9

Rev. Proc. 2023-9 provides the mechanics of the ACM calculation, which remains relatively unchanged from Rev. Proc. 92-29, with updates to certain defined terms. Specifically, Rev. Proc. 2023-9 added the term “qualifying project” to mean any project of a developer for which common improvement costs will be incurred, provided such costs are properly allocable to (1) contracts that are properly accounted for under the CCM and for which one or more benefited units are the subject matter and/or (2) benefited units, the sales of which are properly accounted for under an accrual method.

Under the ACM, a developer allocates the estimated cost of common improvements to all benefited units in the qualifying project (and, in the case of a developer using the CCM, all the CCM contracts from the qualifying project). The allocation is made using any method that is applied on a consistent basis within that qualifying project and that reasonably reflects the benefits provided to the units (or the CCM contracts) in the qualifying project. Rev. Proc. 2023-9 provides examples of reasonable allocation methods, including a pro rata allocation of the estimated cost of common improvements or an allocation based on relative costs to be incurred, the relative size of the benefited unit, or the relative fair market value of the benefited unit.

The estimated cost of common improvements is equal to the amount of common improvements incurred under Sec. 461(h) as of the end of the tax year, plus the amount of common improvements a developer reasonably expects to incur under Sec. 461(h) during the 10 succeeding tax years. The estimated cost of common improvements may change from year to year. Notably, the ACM does not affect the application of general capitalization rules to developers under Secs. 263(a) and 263A.

Administrative relief and potential earlier inclusion of costs

Real estate developers that use an accrual method of accounting or the CCM should analyze the guidance in Rev. Proc. 2023-9 in determining when estimated common improvement costs should be included in the basis of property held for sale. Real estate developers that want to use the ACM will need to file an accounting method change for tax years beginning after Dec. 31, 2022.

Generally, Rev. Proc. 2023-9 is welcome relief, as it seeks to alleviate some of the burdensome requirements of Rev. Proc. 92-29, such as the requirement to file detailed information with the initial request, file annual statements for each project, or extend the statute of limitation. Taxpayers that apply the ACM under Rev. Proc. 2023-9 may also find that common improvement costs are includible in the basis of property sold prior to when those costs would be includible under the provisions of Sec. 461.

Editor Notes

Christine M. Turgeon, CPA, is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in New York City. For additional information about these items, contact Turgeon at christine.turgeon@pwc.com. Contributors are members of or associated with PricewaterhouseCoopers LLP.