One question real estate developers are faced with is when to capitalize and when to expense costs incurred before, during and after production.
As a result of the Tax Cuts and Jobs Act (“TCJA”), additional analysis may be required to determine the appropriate recognition of costs, depending on whether the taxpayer is considered a large business taxpayer or a small business taxpayer.
As part of the TCJA, the threshold in determining whether small business taxpayers meet the exception for following real estate capitalization guidelines under Section 263A was increased to $25 million. This provides an opportunity for those small business taxpayers to potentially deduct certain indirect expenses related to the production of real property in the year the deductions are incurred. In determining whether a taxpayer is considered a small business taxpayer, it must meet the gross receipts test under Section 448(c) and not be considered a tax shelter. The gross receipts test under Section 448(c) is met if the taxpayer’s average annual gross receipts for the past three taxable years does not exceed $25 million (this amount is adjusted for inflation). However, when performing this calculation under Section 448(c), the taxpayer must consider the aggregation rules and include other entities that meet those rules in determining the gross receipts figure.
If an entity is under the $25 million gross receipts threshold, only costs directly associated with the production of real property are required to be capitalized. Other costs such as interest, real estate taxes and insurance may be expensed as incurred and not capitalized in the basis of the real property. If the entity now meets this exception threshold as a small business taxpayer (and previously did not under the prior regulations), the taxpayer is required to file Form 3115 to elect a change in accounting method to apply these regulations. If a taxpayer does not file for the change in accounting method it will be required to capitalize costs as a large business taxpayer as explained below.
For those entities exceeding the gross receipts threshold of $25 million, the recording of costs are not as straight forward. These entities are required to follow the regulations under code Section 263A which requires capitalization of certain indirect costs related to the production of real property. Below is a useful guide to how those costs should be recorded before, during and after the production period.