Capitalizing Unimproved Land Development Costs
A recent court ruling determined that a land developer must capitalize numerous indirect costs related to developing raw land.
The Tax Court based its decision on Internal Revenue Code Section 263A, which generally requires that with certain production costs, the developer must capitalize the expenditures as part of inventory instead of taking a current deduction. In February 1995, the Tax Court's decision in Von-Lusk v. Commissioner required a real property developer to capitalize as production costs the fees for consulting, advertising, market research, engineering, and obtaining permits and zoning variances-even though no physical activity had commenced with respect to the raw land. Although the decision may be distinguishable from other taxpayers' situations, the Internal Revenue Service (IRS) may attempt to rely on the court's expansive definition of "production" and require developers to capitalize costs of preparing property for future physical development and ultimate sale.
The taxpayer in Von-Lusk was a limited partnership formed for the purpose of managing, holding, and developing raw land. The land was initially contributed to the partnership upon its formation. The 50 percent general partner, a residential and commercial real estate development company, hired contractors, lobbyists, engineers, architects, and others to perform services for the various partnerships in which it had an interest. On behalf of the partnerships, these independent contractors met with government officials, obtained building permits and zoning variances, negotiated permit fees, performed engineering and feasibility studies, and drafted architectural plans. The independent contractors billed their costs directly to each partnership receiving the contractors' services. In addition, an affiliate of the general partner provided management services such as accounting and administration for the taxpayer and other partnerships.
During the years at issue, the taxpayer did not satisfy certain county conditions for the property. As a result, no building permits had been obtained, although the property was zoned for residential development. No physical development had begun. The taxpayer did not engage in any active sales efforts during the years at issue.
The taxpayer deducted the amounts paid to the independent contractors on its return under "other deductions" (for consultants, advertising, insurance, market research, off-premise sales, and other costs). Advertising, market research, and off-premise sales include the costs of advising Von-Lusk on the product mix and pricing for the property. The other costs include the management services. The IRS challenged all of these deductions, asserting that they must be capitalized under §263A.
Tax Court Ruling
The court held that the taxpayer was involved in the "production" of its raw land for purposes of §263A, as defined in §263A(g) and the underlying regulations, requiring the tax-payer to capitalize a proper share of the indirect costs attributable to the property. The court characterized the contractors' activities as examples of production work that is "ancillary to actual physical work on the land and are as much a part of the development project as digging a foundation or completing a structure's frame." According to the court, "(t)hese activities represent the first steps of development." The court viewed the legislative history underlying §263A as requiring a "broad definition" of the term produce to carry out Congress' intention for a single set of comprehensive rules applied "from the acquisition of property, through the time of production, until the time of disposition." The court similarly concluded that the costs of management services had to be capitalized.
The court's conclusion in Von-Lusk that the term produce encompasses a broad range of development activities that do not involve physically altering raw land is a broader interpretation of §263A than some developers currently follow. The interest capitalization rules under §263A(f) require that interest be capitalized only during the "production period" or typically when physical activity is first performed on the property. In Von-Lusk, the court specifically rejected the premise that the interest capitalization standard for commencement of capitalization should also apply to non-interest expenses. Thus, the Tax Court imposed two separate standards for capitalizing §263A costs. For interest, capitalization begins at the start of the production period or when physical activity begins. For §263A costs other than production- period interest, capitalization begins when any production activity within the meaning of §263A(g)(1) commences-from the time of property acquisition until its disposition.
One possible explanation for the apparently broad scope of Von-Lusk is that the taxpayer asserted that §263A did not apply to its land at all because the property was held for investment. Also, the taxpayer made no attempt to clarify what costs could be capitalized if §263A did apply. In the absence of any specification by the taxpayer, the court deemed that all of the costs can be capitalized.
Other Relevant Authorities
The tax years at issue in Von-Lusk preceded the effective date of the final §263A regulations. The final regulations may be read as requiring that developers capitalize at least some predevelopment costs. Specifically, IRS regulation §1.263A-2(a)(3)(ii) states relative to preproduction costs, that if "property is held for future production, taxpayers must capitalize direct and indirect costs allocable to such property...even though production has not begun. If property is not held for production, indirect costs incurred before the beginning of the production period must be allocated to the property and capitalized if, at the time the costs are incurred, it is reasonably likely that production will occur at some future date. In addition, a real estate developer must capitalize property taxes incurred with respect to property if, at the time the taxes are incurred, it is reasonably likely that the property will be subsequently developed."
The decision also appears to encompass certain costs otherwise deductible under existing authority. For example, IRS regulation §1.263A(e)(3)(iii)(A), which specifically excludes from capitalization the costs for marketing, selling, and advertising, and distribution expenses, would appear to apply to the Von-Lusk expenditures for those items. The court, however, effectively read into the regulation a requirement that active sales efforts be conducted during the year in which the deduction is claimed. Since the taxpayer did not satisfy this requirement, the court deemed the regulation inapplicable. Further, with respect to advertising and similar costs, it appears the court was not persuaded by the taxpayer's characterization of certain costs "incurred to advise (the taxpayer) as to the appropriateness of product mix and pricing for the property" as traditional marketing and selling costs that are deductible under §263A. Note, however, that revenue ruling 92-80, 1992-2 C.B. 57, supports the IRS's position that advertising costs are generally deductible.
Von-Lusk also addresses zoning rechallenging costs. In Von-Lusk, some of the fees required to be capitalized under §263A included independent contractor costs for "obtaining building permits and zoning variances." No further description of these costs is provided.
As a result of Von-Lusk and the final §263A regulations, land developers must now be aware that the IRS could take a position that §263A applies to a broader range of non-interest costs than traditionally were thought to be subject to the statute. However, each factual situation must be analyzed independently. Under revenue procedure 94-49, the IRS's guidance for compliance with the final §263A regulations, taxpayers seeking to insulate themselves from audit determinations of deficiencies based on §263A may automatically change their §263A method of accounting to make it conform to the holding in Von-Lusk. Such a change must be made in the first tax year beginning after January 1, 1994.