Calculating gross profits under a long-term contract and scheduling the payment of federal income taxes as construction progresses can be a complicated process that trips up even the most well-intentioned developers. But the issue is all the more important these days, as the popularity of condominium construction is spreading beyond residential dwellings to include hotels, offices, and even shopping centers. A sluggish leasing environment, low interest rates, and high demand for land have combined to make condominium projects more appealing to developers who want to reach clients interested in buying rather than renting space.
The daunting aspect of the percentage-of-completion method is that a developer must recognize income and pay taxes on condominium units that are under contract for sale but have not closed. This can be a serious blow to a developer's cash flow since he or she could wind up owing and paying more taxes some years than he or she is able to collect from unit closings. However, failure to comply with the rules can result in stiff penalties if a developer opts to recognize income later than required, thereby underpaying his or her income taxes on a project in any given year.
Don't be confused by the term "percentage of completion." Under this method of accounting, recognition of income is based on the costs incurred to date—not the degree of a project's physical completion. For example, because a project involves many upfront costs, including the cost of the land, it is not unusual for a developer to incur 40% or more of his or her costs by the time 10 stories, or 25%, of a 40-story condominium tower are constructed. In this case, the income-recognition percentage would be 40% rather than 25%.
Is there any relief from the application of the percentage-of-completion method? Yes, there are some exceptions.
First, small contractors can use the old tax accounting rules for long-term contracts. However, even if a developer can qualify, he or she still must compute the alternative minimum tax under the percentage-of-completion method.
Also, in the early stages of a construction project, a developer can defer the recognition of gross profit under a long-term contract if he or she has incurred less than 10% of the total estimated costs by year end. A developer typically must generate a significant number of pre-sales to obtain construction financing. Therefore, prior to groundbreaking, the soft costs incurred (e.g., architectural, engineering, marketing, and sales charges) may not cross the 10% threshold. Indeed, a developer would benefit by delaying some costs until the second year of a project to avoid triggering the more stringent percentage-of-completion rules. Once the 10% threshold has been reached, it is advantageous for the developer to finish construction and complete the closings as soon as possible to minimize the adverse impact of the percentage-of-completion accounting rules.
In addition, a developer contemplating a townhouse project can design it to be exempt from percentage of completion. Let's say the developer wants to construct 50 buildings on a site. If each of those buildings contains four or fewer dwelling units, his or her project would be exempt from the percentage-of-completion method for regular tax purposes. And if he or she qualifies for the small contractor's exemption, he or she is also exempt from the alternative minimum tax. However, if each building contains five or more townhouse units, the percentage-of-completion method would apply.
Certain high-rise residential construction contracts, such as for a condominium tower, can obtain a partial exemption from the blanket percentage-of-completion method. A 70/30 method allows the developer to use his or her normal method of accounting for 30% of the items in a long-term contract. The other 70% falls under the percentage-of-completion method. This means that the developer may be able to defer 30% of the income recognition until the units are closed.
However, in calculating the alternative minimum tax, a developer must account for 100% of all items under the percentage-of-completion method.
The complexity of the percentage-of-completion method of accounting becomes all too clear as developers wrap up their multi-year construction projects.
One last hurdle for taxpayers to overcome is the Internal Revenue Code's "look-back requirement."
Since a developer has been recognizing income during the construction periods based on estimations of gross profits, he or she must recompute or "look back" at those estimates after the project is completed.
It is very possible that the developer made more money—or less money—than he or she originally projected. If gross profit was understated or overstated, the developer either will owe interest or will be due interest.
Certainly, a real estate venture can be a rewarding experience. However, to truly enjoy the fruits of his or her labor, a developer or contractor needs to master the art of navigating the labyrinth of tax laws that apply to multi-year condominium construction projects.
About the Author:
Alan A. Lips became a partner at Gerson, Preston, Robinson & Company in 2002 after distinguishing himself as an aggressive and knowledgeable tax and auditing consultant for the firm's local and international clients.
Lips, who joined the firm in 1995, concentrates his practice on international taxation, real estate, construction, manufacturing, and business consulting. He serves clients on a full range of matters, including inbound and outbound investment structuring and planning, pre-immigration tax planning, U.S. income and estate tax planning and compliance, and financial accounting and auditing. He has worked with clients from all over the world, especially South American individuals and companies seeking to acquire residential and commercial real estate in the United States.
Lips received a bachelor's degree in accounting with honors from the University of Georgia in 1993 and an executive master's degree in taxation from Florida International University in 1998. His professional career began with a national accounting firm in Atlanta, where he focused on auditing manufacturing clients. Lips is a member of the American and Florida Institutes of Certified Public Accountants and the Georgia Society of Certified Public Accountants.
Active in the community, Lips is a member and serves on the board of the Young Presidents Club of the Mount Sinai Medical Center and the Miami Beach Development Advisory Board. He is also the president of the Florida Chapter of the American Men's ORT, a member of the Aventura Marketing Council Roundtable, chairman of the Young Professionals Anti-Defamation League, a board member of Help, Inc., and a member of the Jewish National Fund Board of Directors. He and his wife, Lisa, have three children.
