February 7, 2023
IRS issues guidance on the optional safe harbor accounting method for real estate developers
In Revenue Procedure 2023-9, the IRS outlines guidance on the Alternative Cost Method, which real estate developers may use to account for certain common improvement costs. Revenue Procedure 2023-9 obsoletes Revenue Procedure 92-29, 1992-1 C.B. 748, and is effective for tax years beginning after December 31, 2022.
Real estate developers that use an overall accrual method of accounting and are contractually obligated or required by law to provide common improvements as part of a qualifying project may use the Alternative Cost Method. Revenue Procedure 2023-9 defines "common improvement" as any real property or real property improvements "that benefit two or more units that are separately held for sale by a developer." A "qualifying project" is any project for which a developer will incur common improvement costs, provided the costs are properly allocable to (1) contracts that are properly accounted for under the completed contract method (CCM), as described in Treas. Reg. Section 1.460-4(d), and for which one or more benefitted units are the subject matter; or (2) benefitted units, the sales of which are properly accounted for under an accrual method.
The developer must apply the Alternative Cost Method to all qualifying projects of a trade or business. The developer, however, may not use the common improvement costs incurred for one qualifying project in the Alternative-Cost-Method calculations of another qualifying project.
Application of the Alternative Cost Method
Developers using an accrual method of accounting
Under the Alternative Cost Method, eligible developers that account for the sale of units under an accrual method may include in the basis of units sold their allocable share of the estimated cost of common improvements regardless of whether the costs are incurred under IRC Section 461(h), subject to the alternative cost limitation described in Section 5.04 of Revenue Procedure 2023-9.
Developers using CCM
If an eligible developer uses the CCM to account for a CCM contract, the developer may treat a CCM contract's allocable share of the estimated cost of common improvements as incurred allocable contract costs for purposes of:
The costs may be treated as incurred allocable contracts costs, regardless of whether the costs are incurred under Section IRC 461(h), subject to the alternative cost limitation described in Section 5.04 of Revenue Procedure 2023-9.
Determining allocable share of estimated common improvement costs
Revenue Procedure 2023-9 requires developers to allocate the estimated cost of common improvements to all the benefitted units in the qualifying project (or, in the case of a developer using the CCM, all the CCM contracts from the qualifying project). Developers make the allocation by "using any method that is applied on a consistent basis within that qualifying project and reasonably reflects the benefits provided to the units (or the CCM contracts) in that qualifying project." The estimated cost of common improvements at the end of the tax year equals the common improvement costs under IRC Section 461(h) at the end of the tax year, plus the common improvement costs the developer reasonably expects to incur under IRC Section 461(h) over the next 10 tax years. If it's determined that the developer understated or overstated the estimated cost of common improvements for a particular year (based on events that occur in a subsequent year), the developer allocates the adjustment to all of the benefitted units in the project, including units sold (or CCM contracts completed) in prior tax years. However, any portion of the adjustment allocated to units sold in prior years is taken into account in the current year (i.e., the year the determination is made) in lieu of filing an amend return, subject to the alternative cost limitation.
Section 5.04 of Revenue Procedure 2023-9 limits the estimated cost of common improvements to the total common improvement costs incurred under IRC Section 461(h) for the qualifying project as of the end of the tax year (i.e., alternative cost limitation). If the limitation prevents a developer from claiming the entire allocable share of the estimated cost of common improvements in a tax year, the developer may carry forward any costs not included in the basis of the units sold or treated as incurred allocable contract costs of completed CCM contracts to a subsequent tax year, provided additional common improvement costs were incurred under IRC Section 461(h). Revenue Procedure 2023-9, however, requires the costs incurred in a subsequent year to be allocated first to the units already sold (or CCM contracts completed) and then to the units sold, or CCM contracts completed, in the subsequent year. The alternative cost limitation applies on a project-by-project basis.
Revenue Procedure 2023-9 contains several examples that illustrate the application of the Alternative Cost Method.
Interaction with other provisions of the Code
The Alternative Cost Method does not affect the application of the general capitalization rules to developers under IRC Section 263(a) and IRC Section 263A. Thus, common improvement costs incurred under IRC Section 461(h) are allocated among the benefitted units and may provide the basis for additional computations (for example, interest capitalization under IRC Section 263A(f)).
Record retention and failure to comply
The Commissioner may change a developer's accounting method for its common improvement costs if the developer fails to provide required records to the Commissioner in a timely manner or fails to demonstrate reasonable cause for failing to maintain and produce the records. The records must have sufficient information to support:
The developer must keep these records as long as they may be material in the administration of an internal revenue law. At a minimum, the developer must retain the records for as long as it may incur costs for the qualifying project or may take those costs into account, and for three years "after the filing of the federal tax return for the last [tax] year in which the costs of the qualifying project may be incurred or taken into account."
If a developer fails to comply with the requirements in Revenue Procedure 2023-9, the developer may not use the Alternative Cost Method. Therefore, the developer may only include the common improvement costs incurred under IRC Section 461(h) in the basis of benefitted units or in allocable contract costs of a project, for purposes of determining (1) the gain or loss resulting from the sale of the units, or (2) the income once a CCM contract is completed.
Accounting method change
Under Revenue Procedure 2023-9, a change to the Alternative Cost Method is an accounting method change to which IRC Sections 446(e) and 481 apply. If a developer wants to make this change, the developer must use the automatic change procedures of new section 20.14 of Revenue Procedure 2022-14 and Revenue Procedure 2015-13 (or its successor).
Specifically, Section 20.14 of Revenue Procedure 2022-14 applies to a taxpayer:
(a) that wants to change to the Alternative Cost Method described in [Revenue Procedure] 2023-9, for all of its qualifying projects within a trade or business, including taxpayers that want to change their method of allocating adjustments to the estimated cost of common improvements for all of their qualifying projects within a trade or business;
(b) that, on the first day of the first [tax] year beginning after December 31, 2022, in the same trade or business, uses the [Revenue Procedure 92-29] alternative cost method under for one or more qualifying projects that are in progress and an accrual method under [IRC Section] 461 to account for common improvement costs for one or more qualifying projects that are in progress (legacy rule). For purposes of this section, a qualifying project is in progress if the developer has sold at least one unit in the project in a prior [tax] year (or in the case of a developer that uses the completed contract method, has completed at least one contract in the project in a prior [tax] year) and holds units in the project available for sale during the [tax] year. In this situation, the taxpayer is not required to change to the Alternative Cost Method for such qualifying projects in progress using an accrual method under [IRC Section] 461 as long as all new qualifying projects in the trade or business are accounted for using the Alternative Cost Method in accordance with [Revenue Procedure 2023-9; or
(c) that, on the first day of the first [tax] year beginning after December 31, 2022, wants to change from the 92-29 alternative cost method to an accrual method under [IRC Section] 461 for all of its qualifying projects in a trade or business.
Section 20.14 of Revenue Procedure 2022-14 allows developers wishing to change to the Alternative Cost Method (including a change to apply the legacy rule) to use a short Form 3115 instead of the standard Form 3115 if the developer makes the change for its first tax year beginning after December 31, 2022, the IRC Section 481(a) adjustment for each applicable change is zero, and the taxpayer either:
Developers making more than one accounting method change under Revenue Procedure 2023-9 for the same year of change may not net the IRC Section 481(a) adjustments to determine whether they meet the requirements to use the streamlined method change procedures. Revenue Procedure 2023-9 also waives the five-year eligibility rule in Section 5.01(1)(f) of Revenue Procedure 2015-13 for the developer's first tax year beginning after December 31, 2022.
Revenue Procedure 2023-9 is effective for tax years beginning after December 31, 2022 (2023 tax years). Therefore, beginning with 2023 tax years, developers may no longer use Revenue Procedure 92-29's Alternative Cost Method (even if consent was received); instead, they must comply with the rules and conditions in Revenue Procedure in 2023-9 if they desire to use the Alternative Cost Method.
Complying with the rules and conditions of Revenue Procedure 2023-9 may be less administratively burdensome compared to the effort required to comply with Revenue Procedure 92-29. In particular, developers will no longer be required to obtain separate IRS consent for each project; instead, developers can obtain IRS consent for all qualifying projects by filing an automatic accounting method change (and, in some circumstances, may be eligible to use streamlined accounting method procedures). Developers may use any reasonable method to allocate common improvement costs within a project, so long as such methods are applied consistently once selected. This provides developers an opportunity to revisit allocation methodologies and change to new methods through an automatic accounting method change.
While developers desiring to change to the Alternative Cost Method are not required to use such method for projects in progress at the beginning of the year of change that were accounted for under an accrual method, it appears those developers will need to change projects in progress at the beginning of the year of change that were accounted for under the Revenue Procedure 92-29 alternative cost method to the new method. This will require developers to evaluate those projects and calculate an IRC Section 481(a) adjustment resulting from the change.
Published by NTD’s Tax Technical Knowledge Services group; Jennifer A Brittenham, legal editor