IRS Eases Hurdles to the Alternative Cost Method (ACM) for Common Improvement Cost Allocations
Ryan Kertes, CPA
With the release of Revenue procedure 2023-9, the IRS has greatly reduced the administrative burden of developers using the alternative cost method (ACM) to include common improvement costs in the basis of units developed for sale. Prior to the release of the revenue procedure, developers had to request permission on a project-by-project basis and agree to extend the statutory period of limitation for assessing a deficiency in tax for employing the method. The adoption of the new method is an automatic process change that is accomplished by filing a Form 3115 for the year of implementation. The new revenue procedure will reduce the administrative burden for developers currently using the method, and it will make the method a more appealing option for those not currently utilizing it.
Under the “economic performance” test in Internal Revenue Code Sec. 461, developers cannot add common improvement costs to the basis of units until the costs are incurred. As a result, any common improvement costs that were not incurred prior to an individual unit sale could not be included in the basis when determining the gain or loss resulting from the sale. Therefore, the first units sold in development projects would have a lower basis, with disproportionate cost allocation to units sold later.
For tax purposes, “common improvement” means that any real property or improvements that benefit two or more units that are separately held for sale. You must be: 1) Contractually obligated or required by law to provide the common improvement; and 2) Not able to recover the cost through depreciation. Typical examples include streets, sidewalks, sewer lines, playgrounds, clubhouses, tennis courts and swimming pools.
The IRS provided some limited relief more than 30 years ago in Rev. Proc. 92-29. It outlined procedures by which developers could include the estimated cost of common improvements in the basis of units sold — even if the costs were not yet incurred — under the ACM. The ACM accelerates deductions for common improvement costs, allowing developers to better match income to related expenses.
To illustrate the method, imagine you will build ten homes as part of the same project over three years. You estimate that the common improvement costs will total $500,000.
Under the ACM, each house’s allocable share of the estimated cost of the common improvements is $50,000 ($500,000/10 houses). If, in the first year, you sell four houses and incur $250,000 in common improvement costs, you can include $200,000 ($50,000 x 4) of the estimated cost in the aggregate basis of those houses. Without the ACM, you generally must allocate the $250,000 in incurred costs to all ten houses, including only $100,000 ([$250,000/10] x 4) of the costs in the aggregate basis of the four houses sold in Year 1.
The ACM is, however, subject to the alternative cost limitation. You can deduct the lesser of 1) the amount under ACM, or 2) the actual costs incurred to date. If the limit applies, you can deduct the excess of the ACM over actual costs in later years as the costs are incurred.
Moreover, developers have found the procedures required by Rev. Proc. 92-29 quite burdensome. For example, you had to request permission to use the ACM on a project-by-project basis and agree to extend the statute of limitations for IRS review of your tax returns. You also were required to make extensive disclosures in the initial election and subsequent detailed annual statements for the life of the project. These hurdles outweighed the benefits in the minds of many developers.
The new rules, which took effect Dec. 31, 2022, are intended to reduce the administrative, recordkeeping and compliance burdens. For starters, it makes the ACM a standard method of accounting, which means that once you adopt it, the method applies to all projects going forward — you need not make project-by-project elections. The annual disclosure requirements are eliminated, and using the ACM will not extend the audit statute of limitations. The guidance also makes clear that the ACM is available to developers subject to the completed contract method (CCM).
Note that, while the ACM will apply to all qualifying projects going forward, the alternative cost limitation is still applied on a project-by-project basis. Any common improvement costs incurred for one qualifying project cannot be included in the ACM calculations for a separate qualifying project.
The term “qualifying project” refers to project on which common improvement costs will be incurred that are properly allocable to:
- Contracts properly accounted for under the CCM and for which one or more benefitted units are the subject matter; and/or
- Benefitted units, the sales of which are properly accounted for under an accrual method.
You can employ any reasonable method to define a project in light of the particular common improvements. For example, a developer is using a reasonable method when it separates commercial and residential projects that provide for different common improvements.
What if your estimate of common improvement costs changes? The correction is made in and for the year you determine a change is necessary. For units already sold in previous taxable years, their share of the adjustment is addressed with a current-year adjustment to income rather than an amended return or an administrative adjustment request.
Making the Change
Developers can adopt the ACM by filing the short version of IRS Form 3115, “Application for Change in Accounting Method.” Before you act, consult with your ORBA advisor first to ensure the ACM is best for your circumstances.
Prepare Now to Prove Your Real Estate Professional Status
Anita Wescott, CPA
Real estate professional status can provide taxpayers some significant benefits come tax time. The requirements to establish such status are demanding, though, and you will need the right records to back it up.
The Tax Benefits
The passive activity loss rules can limit your ability to offset net losses from passive activities, such as rental real estate businesses, against nonpassive sources of income like your wages. If you do not have passive activity income, you must carry forward passive activity losses until you do.
The IRS does allow some exceptions to the rules, including for certain real estate professionals. If you satisfy the requirements, you can apply rental losses against nonpassive ordinary income.
Real estate professionals also may be able to avoid the 3.8% net investment income tax (NIIT) on rental income. Generally, if you qualify as a real estate professional and participate more than 500 hours in rental activities during the current tax year — or more than 500 hours per year in any five of the previous ten years — your rental income is not subject to the NIIT.
Real Estate Professional Requirements
You must satisfy two requirements:
- More than half of the personal services you performed in businesses during the tax year were performed in real property businesses in which you materially participated (see below); and
- You performed more than 750 hours in those real property businesses during the tax year.
You cannot count work you performed as an employee in a real property business unless you were a “5% owner” of the business. You were a 5% owner if you owned more than 5% of the business’s outstanding stock, outstanding voting stock, or capital or profits interest.
You also cannot count your spouse’s personal services if you file a joint return. However, you can count your spouse’s participation in an activity when determining if you materially participated in a real property business activity, even if your spouse did not own an interest in the activity and you do not file a joint return.
Material Participation Tests
The IRS defines “material participation” as regular, continuous and substantial involvement in business operations. You materially participated in a real property business if you meet any of the following tests during the tax year:
- You participated for more than 500 hours.
- Your participation was substantially all of the participation in the business by anyone, including individuals without an ownership interest (for example, employees).
- You participated for more than 100 hours and at least as much anyone else, including those without ownership interests.
- The activity is a “significant participation” activity, and you participated for more than 500 hours. A significant participation activity is any business activity in which you participated for more than 100 hours but did not, under the other six tests, materially participate.
- You materially participated in the business, under at least one of the other tests, for any five of the ten immediately preceding tax years.
- The business is a “personal service” activity — that is, a business where capital is not a significant income-producing factor, such as legal, architectural or consulting services — in which you materially participated for any three preceding tax years.
- You participated in the business on a regular, continuous and substantial basis during the year based on all of the facts and circumstances and you participated for more than 100 hours. Managing a business is not relevant to this test if: a) Any other person received compensation for managing the activity; or b) Any person spent more hours during the tax year managing the business than you did (whether compensated or not).
Document, Document, Document
You must be able to prove that you satisfy one of the material participation tests, particularly for those tests with hours requirements. You can use any “reasonable method” to establish your participation, including appointment books, calendars or narrative summaries that describe the number of hours spent on each project or property.
While you are not required to keep contemporaneous daily time reports, logs or similar records, you would be wise to do so. Numerous cases have demonstrated that neither the IRS nor the courts will accept “ballpark” estimates. They also are skeptical of records prepared after the fact in anticipation of litigation.