Under the “alternative cost method” of Revenue Procedure 92-29, 1992-1 C.B. 748, a developer may allocate estimated costs of common improvements to the basis of lots sold despite the limitations imposed by IRC § 461(h). Developers must obtain permission from the Service to use the alternative cost method.
Common improvements must have the following qualities:
(1) Be real property or real property improvement that benefits two or more properties separately held for sale;
(2) The developer must be contractually obligated or required by law to provide the improvement; and
(3) The improvement must not be depreciable by the developer
The common improvement has to be contractually obligated or required by the governing body of law. For example, an agreement to provide improvements in
exchange for a building permit is a common improvement (see Herzog Building Corp. v. Commissioner, 44 T.C. 694 (1965). A statement in a buyer’s HUD report that the
developer will provide improvements does not qualify as a contractual obligation (see Rev. Rul. 76-247, 1976-1 C.B. 217), nor does an oral promise to a buyer to provide
improvements (see Bryce’s Mountain Resort, Inc. v. Commissioner, T.C. Memo. 1985- 293 (1985).
Common improvements vary depending on the type of development. Some normal examples of common improvements include:
• Streets • Sidewalks • Sewer lines • Playgrounds • Clubhouses • Tennis Courts • Swimming Pools
For any taxable year, the estimated cost of common improvements is equal to the amount of common improvement costs incurred under IRC § 461(h) plus the amount of common improvement costs the developer reasonably anticipates it will incur during the 10 succeeding taxable years. See Rev. Proc. 92-29, Section 2.02(1).
A developer may include in the basis of properties sold their allocable share of the estimated cost of common improvements without regard to whether the costs are incurred IRC § 461(h). There is an important limitation, however. As of the end of any taxable year, the total amount of common improvement costs included in the basis of the properties sold may not exceed the amount of common improvement costs that have been incurred under IRC § 461(h). If the alternative cost statutory limitation prevents a developer from including the entire allocable share of the estimated cost of common improvements in the basis of the properties sold, the costs not included can be deducted in the subsequent taxable year(s) to the extent that additional common improvement costs have been incurred under IRC § 461(h). See Rev. Proc. 92-29, Section 4.01.
Which business division of the IRS that a taxpayer requests the use the alternative cost method provided by Rev. Proc. 92-29 depends on the taxpayer’s business and size. The Large and Mid-Size Business Division (LMSB) generally serves corporations, S corporations, and partnerships with assets in excess of $10 million. The Small Business/Self-Employed Division (SB/SE) generally serves corporations, S corporations, and partnerships with assets less than or equal to $10 million, and
individuals filing an individual federal income tax return with accompanying Schedule C. Taxpayers must comply with certain requirements in order to use the Alternative Cost Method.
(1) File a request with the Area Director (for SB/SE) or Director, Field Operations (LMSB) and attach a copy to return, in accordance with section 6.01 of Rev. Proc. 92-29 on or before the due date of the return for the taxable year in which the first lot is sold. The request to use the Alternative Cost Method must include:
• Developer’s identifying information • Description of the project
• Schedule showing the lots covered by the request and the costs to acquire such lots
• Schedule showing the common improvements required to be provided and information concerning the estimated cost of such improvements, the cost allocable to each lot, and the estimated date of completion of the
improvements
(2) Sign a restricted consent extending the statute of limitations on assessment with respect to the use of the alternative cost method. The restricted consent procedures require:
• Developer must extend the statute of limitations for each year the alternative cost method is used
• Limitations period must be extended to one year beyond the expected completion date of the project
• Developer uses Form 921 (or 921A if a partnership) for this purpose (3) File an annual statement with the Area Director or Director, Field
Operations(and attach copy to return) in accordance with section 8.02 of Rev. Proc. 92-29. The annual statement must include:
• Developer’s identifying information
• Date of expiration of the extended statute of limitations • Description of the project
• Schedule showing an updated estimated cost of common improvements, the manner of allocating the costs among lots, the lots sold as of the end of the previous taxable year, the costs incurred under 461(h), and the costs included in the basis of lots sold
A developer that fails to substantially comply with the provisions of Rev. Proc. 92-29 will not be permitted to use the alternative cost method and therefore may not include common improvement costs that have not been incurred under IRC § 461(h) in the basis of properties for purposes of determining gain or loss from such properties.
Example – Statute of Limitations:
A developer (partnership) applied for Rev. Proc. 92-29 approval for calendar tax year 1998 and agreed to the statute extension as required. A six-year common improvement period was requested. The Form 921 consent was secured at the time that the
approval was issued and covered tax years ending 1998, 1999, 2000, 2001, 2002, and 2003. Tax returns for all project years were filed timely. During 2004 the developer came under audit for the 2003 return. The audit was completed by late 2004. The agent found that major aspects of the development disqualified it for Rev. Proc. 92-29
treatment and proposed audit adjustments for all six project years (1998 through 2003). The 1998, 1999, 2000, and 2001 statutes for Rev. Proc. 92-29 adjustments expire April 15, 2005.
The statute of limitations for all project years is computed as follows: • Projected completion year for the common improvements: 2003
• Return (1065) due date for project completion year: April 15, 2004 Add one year to project completion year return filing date: April 15, 2005
Normal 921 Rev. Proc. 92-29 Date Return Statute Statute Statute Filed Expiration Expiration Expiration ************* ************* ************ ************ 1998 April 15, 1999 April 15, 2002 April 15, 2005 April 15, 2005 1999 April 15, 2000 April 15, 2003 April 15, 2005 April 15, 2005 2000 April 15, 2001 April 15, 2004 April 15, 2005 April 15, 2005 2001 April 15, 2002 April 15, 2005 April 15, 2005 April 15, 2005 2002 April 15, 2003 April 15, 2006 April 15, 2005 April 15, 2006 2003 April 15, 2004 April 15, 2007 April 15, 2005 April 15, 2007
Example – Statute of Limitations:
Assume the same facts as above except that the developer has not yet filed the completion year (2003) tax return. The statute of limitations for all project years is as follows.
Normal 921 Rev. Proc. 92-29 Date Return Statute Statute Statute Filed Expiration Expiration Expiration ************* ************* ********* ********* 1998 April 15, 1999 April 15, 2002 open open
1999 April 15, 2000 April 15, 2003 open open 2000 April 15, 2001 April 15, 2004 open open 2001 April 15, 2002 April 15, 2005 open open 2002 April 15, 2003 April 15, 2006 open open 2003 not filed open open open
Rev. Proc. 92-29 Section 10 provides that “If the first year in which the alternative cost method is improperly used is no longer open for assessment of a deficiency of tax, the
Commissioner may use her statutory discretion to change the taxpayer’s method of accounting in a later year and impose an adjustment under section 481(a) of the Code.” This allows the IRS to make a cumulative adjustment/correction for all barred years in the earliest open year.
Example – Allocation of Common Improvements:
A developer will build 20 units of three cost classes (5 condo units, 6 town home units, and 9 single family homes) on a tract of land. The developer is contractually obligated to provide the common improvements and estimates that the common improvements will cost $1,400,000 (including the cost of land associated with the common improvements). The common improvements are allocated as follows: $200,000 for the 5 condominium units, $300,000 for the 6 town homes, and $900,000 for the 9 single-family lots. The cost of the common improvements is not properly recoverable through depreciation by the developer. Common improvement costs are allocated as follows: 5 condo units @ $40,000 each, 6 town home units @ $50,000 each, and 9 single family lots @ $100,000 each.
Example – Allocation of Common Costs Compared – Rev. Proc. 92-29 vs. IRC § 461(h):
A developer building 10 properties of equal value on a tract of land is contractually obligated to provide common improvements. The common improvements will benefit all the lots in the development equally. The developer estimates that these common
improvements will cost $1,000,000 (including the cost of the land associated with the common improvements). The cost of the common improvements is not properly recoverable through depreciation by the developer. Each lot’s allocable share of the estimated cost of the common improvements is $100,000 ($1,000,000/10 lots). In year 1, the developer incurs $250,000 in common improvement expenses and sell 2 lots.
Under IRC § 461(h), the deduction would be $50,000( $250,000/10 lots = $25,000 X 2 sales = $50,000 ).
However, per Rev. Proc. 92-29 the deduction in year 1 is $200,000. ($100,000 allocation to each lot sold does not exceed the total IRC 461(h) limitation of $250,000).
Example – IRC § 461(h) Limitation:
Year 1: The development has 20 single-family lots and estimated common improvement costs are $1,500,000. The application states that costs are allocated equally to each lot, therefore $75,000 would be allocated to each lot ($1,500,000/20). During Year 1, $300,000 in common improvement costs were incurred and five lots were sold.
Without the IRC § 461(h) limitation, the Rev. Proc. 92-29 deduction for common improvements for Year 1 would be $375,000 ($1,500,000/20 x 5 lots sold). However, the total costs incurred for the common improvements is $300,000, thus the deduction is limited to $300,000. The $75,000 barred in Year 1 is carried forward to Year 2 provided the additional costs are incurred.
Year 2: $600,000 in obligated common improvement costs were incurred and 6 lots were sold. The year 2 deduction consists of both the deduction for current
year’s sales and the unused Year 1 deduction carryforward.
450,000 6 lots sold x $75,000
75,000 Barred amount from Year 1 sales 525,000 Total Deduction for Year 2