A UNICAP exception for real estate development

Editor: Mark Heroux, J.D.

This item highlights an exception to Sec. 263A uniform capitalization (UNICAP) requirements. The specific focus is how real estate owners that develop, hold, and rent their own property can benefit from this exception if they qualify as “small businesses,” meaning their average gross receipts fall under a certain threshold ($29 million for 2023).

Sec. 263A capitalization

To understand the exception for small businesses, a review of the relevant UNICAP requirements is necessary. Generally, real estate producers are subject to Sec. 263A, which requires certain direct and indirect costs to be capitalized to inventory or other property. Sec. 263A(f) provides special rules for the treatment of interest allocable to property produced by the taxpayer. Interest is required to be capitalized only when paid or incurred during the production period and the property has (1) a long useful life, (2) an estimated production period exceeding two years, or (3) an estimated production period exceeding one year and a cost exceeding $1 million.

The production period begins with any physical activity. Examples of physical production activities include clearing; grading; excavating raw land; demolishing a building; gutting a standing building; engaging in construction of infrastructure (roads, sewers, sidewalks, cables, and wiring); and engaging in landscaping activities. When interest is required to be capitalized, Regs. Sec. 1.263A-9 provides a method to calculate the amount: the avoided-cost method.

Typically, real estate developers have significant expenditures subject to capitalization under Sec. 263A. Examples of such costs include interest, real estate taxes, insurance, engineering, design, storage, and rental of equipment. The costs accumulate and are carried on the balance sheet as construction in process until the project is completed. Once the project is placed in service, these costs are included in the fixed-assets basis as nondepreciable land or other depreciable/ amortizable assets. The depreciable and amortizable costs are then recovered over their applicable lives.

The exception for small businesses

For tax years beginning after Dec. 31, 2017, Sec. 263A(i) provides an exception for certain small business taxpayers. Under this exception, qualified small business taxpayers are not required to capitalize costs under Sec. 263A. Further, Regs. Sec. 1.263A-1(j) states explicitly that small business taxpayers are not required to capitalize costs under Sec. 263A “to any real or tangible personal property produced, and any real or personal property described in section 1221(a)(1) acquired for resale, during that tax year.”

In other words, taxpayers that produce property to be held for rent would not be required to carry significant construction-related costs on the balance sheet during development and would generally be allowed an immediate deduction of such costs in the year incurred (or paid, if a cash-basis taxpayer). This accelerates costs that may have otherwise been depreciated over 39 years.

Definition of a small business

A small business taxpayer for this purpose is a taxpayer other than a tax shelter under Sec. 448(d)(3) that meets the gross-receipts test as provided in Sec. 448(c). Generally, the gross-receipts test is met if the taxpayer has average annual gross receipts for the three prior tax years of $25 million or less (indexed for inflation). The amounts indexed for 2022 and 2023 are $27 million and $29 million, respectively.

For purposes of computing the average annual gross receipts, taxpayers must review the aggregation rules contained in Sec. 448(c)(2). Generally, the aggregation rules require the gross receipts of a “parent-subsidiary group,” “brother-sister group,” or a “combined group” under common control to be aggregated. The specific aggregation rules are beyond the scope of this item. (For a discussion of some of them, see “Aggregation Rules Affecting Foreign-Owned Companies” on page 7.) However, the rules are worthy of a detailed review with varying ownership structures in mind to ensure there is not a presumptive aggregation when not actually required. A taxpayer may also change from being a qualified small business taxpayer one year to being a former small business taxpayer the next (or vice versa).

Automatic accounting method change

Small business taxpayers interested in changing their method of accounting to no longer capitalize costs under Sec. 263A are required to obtain automatic consent to change their method by filing a Form 3115, Application for Change in Accounting Method. The form must generally be filed with a timely filed tax return (including extensions). A Sec. 481(a) adjustment must also be calculated as of the beginning of the year of change.

Opportunity for real estate owners with projects under development

To properly classify costs as capitalized or deductible, the tax reporting for land owners and owners with projects under development typically involves many discussions related to the intent of the holding, when or whether construction will commence, tracking when costs are incurred, how they are funded, the timing of loan draws, when physical production commences, when temporary or final certificates of occupancy are obtained, and when the project is officially placed in service. The small business exception to Sec. 263A provides an opportunity to avoid these time-consuming steps and deduct many of the costs that were previously required to be capitalized.

Tax return preparers may also appreciate the minimized need for the infamous avoided-cost method tax workpaper to calculate capitalized interest. Given the current interest rate environment, a qualifying small business taxpayer’s opportunity to expense interest and other costs under Sec. 263A may be significant. A taxpayer would need to evaluate the tax benefit of the immediate recovery of costs. For a taxpayer in a taxable loss position, the benefits of the accelerated deduction may be minimal. The excess business loss limitations under Sec. 461(l) should also be considered. Individual taxpayer facts and circumstances can produce varying results; as such, taxpayers should analyze the direct and indirect impacts of any method change being considered.

Taxpayers that meet the small business taxpayer tests under Sec. 448 are eligible for several measures intended to provide relief in addition to the Sec. 263A exception. The details are beyond the scope of this item but include the potential to use the cash method of accounting, simplified accounting methods for inventories under Sec. 471, and the exception from Sec. 163(j) interest limitations.

Editor Notes

Mark Heroux, J.D., is a tax principal in the Tax Advocacy and Controversy Services practice at Baker Tilly US, LLP in Chicago.

For additional information about these items, contact Heroux at mark.heroux@bakertilly.com.

Contributors are members of or associated with Baker Tilley US, LLP.