| Careful Attention to Tax Reporting May Hold Some Relief for Troubled Properties
By W. Michael Howlett, Cherry, Bekaert & Holland, L.L.P. (CB&H)
Email: mhowlett@cbh.com
As recent headlines have been quick to indicate, the economy is still feeling the impact of the slowdown in the real estate market. Although the rapidly increasing prices and demand for housing we saw in 2001-2005 were unsustainable and many people feel that we are now experiencing more normal times in the housing sales market, builders and developers have been hit with a one-two punch of high land prices followed by a slowing market for sales.
As a result, lot prices have dropped in many cases below what builders paid as recently as a year or two ago, extending the timeline for moving the lots and thereby increasing the interest builders will pay over the life of the project. However, there are tax strategies available to builders and developers that could prove useful in mitigating the tax effects on selling lots or condos.
Lots or condos for sale by builders and developers are often discussed in terms of inventory since their sale, similar to the sale of inventory by a retailer, results in ordinary income. In general, condos held by a developer are treated for tax purposes no differently than books are for a bookstore in that the cost of the item is expensed at the time it is sold.
However, there is one important distinction – if the current market price of a book falls below what the store paid for it, then the store can write down the value of the inventory item to current market value. This inventory valuation method, lower of cost or market, is allowed for tax reporting and can result in a current expense even though the item of inventory remains unsold.
But the tax rules governing real estate do not work the same way. Builders and developers cannot value their inventory using the lower of cost or market methodology for tax reporting. Unfortunately, the loss in a lot purchased for $180,000 that is now worth $160,000 cannot be recognized until the lot is sold. The same is true for condominiums since the per unit cost, including the price of land, construction costs and financing costs, cannot be expensed until the condo is sold, even if the costs exceed current market value.
So while traditional inventory rules are of no help, builders and developers may potentially find some relief in the reporting of profits in development projects. This is especially true for a project that has spanned both the market’s good and bad times. The cost, and therefore the profit computed on a dollar of sales in a development project (whether lots being developed or condos being built), is determined by computing the total cost of the project and dividing it by the total revenue. In most cases, this process will involve the use of estimates.
These estimates are especially important in today’s market. A quick example can illustrate this. If in 2006 we had $2 million of sales in a project projected to generate a total sales volume of $5 million, and total costs of $4 million with interest expense being relatively small since we assumed enough units would be sold in 2006 and 2007 to repay the financing, then we would have reported about a $400,000 profit in 2006. This represents about a 20 percent profit margin.
If in 2007, prices drop and sales volume goes down, not only will our profit margin drop in the overall, but our costs will rise due to the longer time the debt will be outstanding. Because we would have overreported the profit in 2006 based on the newer information, the profit recognized in 2007 sales could be very small.
Not only would we adjust the profit margin in 2007 to what the new projections show, we would also get a current year reduction in profit due to the over reporting of profit in 2006. This truing up could make the amount of profit recognized in 2007 very small or even a loss. Therefore, by paying careful attention to the remaining sales potential of a project and putting a critical eye to what the future costs will be, more of the income received from current sales may be saved from taxes.
Particular attention needs to be paid to the estimates used in the calculation of the cost of sales for multi-year projects. This is especially important at a time when every dollar is needed to meet overhead and debt obligations. Moreover, builders and developers should be sure to consult with their tax advisors, who can assist in making these calculations properly. By maximizing current year tax savings, you may be able to find some relief during this current period of market adjustment.
This article first appeared in Inside Business on January 26, 2008. Check out Inside Business on the Web daily at www.insidebiz.com and their print publications weekly.
Mike is a Tax Partner with CB&H and a member of the Firm’s Real Estate & Construction Industry Group. |
