Rev. Proc. 2023-9 has streamlined the process by which real estate developers can elect the Alternative Cost Method (ACM) for allocating common improvement costs to the basis of individual units in a real estate development project. For taxable years beginning after Dec. 31, 2022, the ACM allows taxpayers to include a unit’s allocable share of both current and future costs of common improvements in the basis of the unit when sold. The ability to accrue future common improvement costs is limited to the total common improvement costs incurred to date, so it essentially permits current common improvement costs of units not yet sold to be shifted to units that are sold in order for the sold units to reflect their total anticipated gross margin. The ACM is most advantageous to those developers incurring significant common improvement costs such as streets, sidewalks, sewer lines, playgrounds, clubhouses, tennis courts, and swimming pools.
Previous ACM elections under Rev. Proc. 92-29
In general, a developer can’t add the cost of common improvements to the basis of units until such costs are actually incurred. In situations where such common improvements are added after the sale of the benefitted units, this treatment leads to lower basis amounts for units sold earlier and disproportionate allocations of common improvement costs to units sold later.
Rev. Proc. 92-29 provided a means for developers to use the ACM to allocate future common improvement costs to current units sold, but it required rather extensive disclosures for each affected project, both in the initial election and in detailed annual statements included with every tax return over the life of the project. Developers who elected the treatment also had to agree to extend the statute of limitations on their returns from three to 10 years, giving the IRS a much longer window of time to open examinations of affected returns. The election was required to be made on a project-by-project basis, and developers with multiple projects were required to include the burdensome administrative requirements for each individual project.
The ACM benefits eligible taxpayers by allowing them to accrue the costs of future common improvements in the basis of units sold, even if those costs have yet to be incurred. The accrual amount is limited to the cost of all common improvement costs that have actually been incurred, but this is still significantly beneficial even if this limitation is reached. Despite the ACM being very favorable in minimizing taxable income, the administrative burden and statute of limitations extension made it a rather unattractive option for many businesses and those businesses have commented to the IRS for years that the burdens surrounding the ACM were disproportionate compared to almost any other safe harbor method the IRS had ever created.
Advantages under Rev. Proc. 2023-9
The latest IRS guidance responds to those comments by changing the ACM to a standard method of accounting. As a result, once a taxpayer adopts the ACM method it applies to all projects going forward so there is no option to adopt it on a project-by-project basis. There is no election required, no annual disclosures, and no impact on the statute of limitations. In addition, a developer subject to the percentage of completion or completed contract requirements in Section 460 is permitted to use the ACM, which is welcome clarity that was lacking in Rev. Proc. 92-29.
Taxpayers with existing development projects are permitted to adopt the ACM by filing a Form 3115. A taxpayer that was previously applying the ACM in Rev. Proc. 92-29 is required to file a Form 3115 for its 2023 tax year to either adopt the Rev. Proc. 2023-9 version of ACM or move to the traditional accrual method for common improvement costs. For the 2023 tax year, certain accounting method change procedures are relaxed to make it easier for taxpayer to adopt this method.
Taxpayers that have not previously adopted any method with respect to common improvement costs (e.g., newly formed taxpayers, taxpayers just beginning to do real estate development, etc.) can simply begin applying ACM similar to how they adopt all other accounting methods.
Given that the ACM method is generally favorable and many of the downsides of the Rev. Proc. 92-29 version of ACM have been removed, we would expect many developers to adopt the new ACM method. This includes those who may have simply missed the opportunity to make the election previously or those who may have shied away from it given the administrative burden and/or the required extension of the statute of limitations to take advantage of the revised procedures for existing projects.
Managing the transition from 92-29 to 23-9
As with all changes to tax laws and procedures, it’s important for developers to review the impact of Rev. Proc. 23-9 on their business with a tax advisor who can focus on the application of the new rules to the individual facts and circumstances of each taxpayer.
