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CONDOMINIUM PROJECTS TRIGGER
STRINGENT ACCOUNTING RULES

Written By: Alan A. Lips, C.P.A.
Published By: Florida Real Estate Journal
Date: October 1, 2003

When a developer launches a new construction project, he faces some critical tax questions that can affect the financial success of his project. What method of accounting should be used? How should federal income taxes be calculated and paid as construction progresses?

If the developer is planning to construct an office building for lease or build an apartment building for rent, he typically can choose between the cash or accrual method of accounting. However, if he opts to build a condominium residence, condominium hotel or condominium office tower that will take several years to build, a more stringent method of accounting applies. It's called the percentage of completion method, which applies to long-term contracts. A "long-term" contract is generally defined as one that is not completed within the year it is begun.

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 when 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 a 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 could wind up owing and paying more taxes some years than he 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 income taxes on the 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 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 exemptions.

First, small contractors can use the old tax accounting rules for long-term contracts. However, even if a developer can qualify, he 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 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. So, prior to groundbreaking, the soft costs incurred (e,g, architectual, 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 project would be exempt from the percentage of completion method for regular tax purposes. And if he qualifies for the small contractor's exemption, he also is 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 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 period based on estimations of gross profits, he 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 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 one's labor, a developer or contractor needs to master the art of navigating the labyrinth of tax laws that apply — especially to multi-year condominium construction projects.