MLR

Building cost or expense? It makes a difference at tax time

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The IRS requires that some costs of building a house or other structure must be treated as a cost of the building rather than an expense.

house plans

This has the effect of reducing expenses in the current period and increasing the cost of inventory of houses on hand. It falls under the Uniform Capitalization Rules (UNICAP or IRC Sec 263A).

UNICAP allocations

Applying the UNICAP rules can be a daunting task. There are multiple correct ways to allocate.

When a cost is capitalized, it is included as a part of the cost of the product being sold. For direct materials and direct labor, this is not difficult because they are directly related to the production activity. The difficult part lies in the area of indirect costs, sometimes referred to as overhead or burden.

In allocating indirect costs, the taxpayer must first determine which indirect costs should be allocated to the product. Then, an allocation must be made to determine the portion of that cost that is to be capitalized and the part that may be expensed.

Indirect costs are considered “properly allocable” to the property when the costs either directly benefit the property or are incurred because of production activities.

The IRS has guidelines about what costs are included in the cost of the product, but does not specify one method to accomplish the allocation. The guiding principle here is that the allocation should be reasonable and defensible, while within the existing IRS rules.

Although UNICAP applies to all businesses that produce a product, there are some special issues in regard to home builders.

Costs incurred before, during and after the construction or development of the property are included among those that must be capitalized. Pre-construction and pre-development costs include carrying costs, real estate taxes and zoning costs. Construction and development period costs are incurred during construction or development.

Once the property is placed in service or is ready for sale, post-construction or development costs must be considered. Related costs incurred in this period are capitalized. Interest costs are capitalized only during the construction or development stage.

A case study

Frontier Custom Builders builds custom homes. The company maintained that its business model was centered around sales and marketing and was different from other homebuilders.

Its premium prices and profitability derived not from cost control, but from the creativity of its sales staff, designers, decorators and marketing employees.

Because Frontier used independent contractors to actually build the houses, the company maintained that they were not a “producer” as defined in the law.

Frontier was challenged by the IRS with a deficiency notice of almost $1.9 million. The Tax Court determined that Frontier was engaged in production activities and subject to UNICAP rules.

The court then applied its ruling to expenses that Frontier had deducted. The court found that officer compensation was partially allocable to production-related services, because the corporate officer would meet with clients to discuss design.

He also performed design activities and reviewed monthly production reports. The officer’s executive assistant was involved in these activities and her compensation was partially allocable to the cost of the homes in the same ratio as the officer.

The duties of the company’s corporate accountant included payroll. Therefore, a portion of her salary was seen as allocable to the extent of the compensation of production-related employees.

The information technology specialist modified and improved the company’s website which allowed the company to keep track of orders and leads. The court held that a portion of the IT specialist’s salary was allocable to production.

The project managers’ salaries were ruled to be direct costs, so these costs were assigned 100 percent to production.

The importance of keeping contemporaneous time records was highlighted in regard to the salaries of designers and decorators.

These employees spent time in marketing, advertising and selling, but also were involved in design services. Since records of the time spent on each activity were not present, the court assigned their entire salaries to production activities.

The Tax Court applied UNICAP principles to payroll taxes, benefits, insurance, vehicle expenses, annual retreat costs, utility expenses and computer maintenance expenses.

Applicability to home builders

Obviously, all builders are not custom home builders, but the decision reached by the Tax Court in this case emphasizes the importance for all builders of:

1) Maintaining adequate time and expense records

2) Correctly determining what costs are considered production costs

3) Making reasonable allocations of these costs to production activities

Several approaches to accomplish the allocation are given in the IRS Cost Segregation Audit Technique Guide.

There are exceptions to the UNICAP rules, but the one most applicable to builders exempts a taxpayer whose average annual gross receipts for the preceding three years do not exceed $10 million. – John Stancil, CPA