Developer required to capitalize real estate taxes.

The Tax Court recently held, in John. J. Reichel, 112 TC No. 2, that a taxpayer was required to
capitalize real estate taxes paid on real estate home sales properties he intended to, but did not
actually, develop. The court rejected the taxpayer's argument that he was not required to capitalize
the costs, because he took no positive steps to begin producing the property.
The taxpayer (a sole proprietor) had been a real estate developer since 1989. His business consisted
of buying and developing raw land, including: applying for and obtaining zoning variances, grading
plans, street plans, water plans, sewer and storm drain plans, site plans, architectural plans,
environmental feasibility studies and development and construction cost estimates. He then
subdivided the land and sold it to homebuilders. In 1991, the taxpayer bought two parcels of land
with the intention of developing them. However, he never began any "development" activities, citing
adverse economic conditions. He continued to hold the parcels for development.
In 1993, the IRS disallowed the taxpayer's deduction of real estate taxes on these parcels of land on
Schedule C of his tax return. The Service claimed that the taxpayer was required to capitalize all
real estate taxes on the property under Sec. 263A(a)(2)(B), and that the taxpayer was a "producer"
with respect to the parcels under Sec. 263A(b)(1). The IRS noted that Sec. 263A(g)(1) specifies the
term "produce" to mean, among other things, "develop."
The taxpayer argued that Sec. 263A(a)(2) (B) did not require him to capitalize the real estate taxes
until he undertook positive steps to begin developing the parcel, contending that the court's earlier
decision in Von-Lusk, 104 TC 207 (1995), established the principle that some activity had to occur
for production of the property to begin. Because the taxpayer had not undertaken any development
activities on the parcels, he claimed he never began producing them within the meaning of Sec.
263A and, therefore, did not need to capitalize the real estate taxes.
The court responded to the taxpayer's argument by referring to Regs. Sec. 263A-2(a)(3)(ii), which
states 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
future production, indirect costs incurred prior to 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 mls real estate listings at some future date. Because the taxpayer intended to
develop the parcels at some point in the future, he would be required to capitalize the real estate
taxes paid.
The court also disagreed with the taxpayer's interpretation of Von-Lusk, and performed a substantial
review of the legislative intent behind Sec. 263A. In Von-Lusk, the court did not decide whether
capitalization was required for expenses incurred before production began, but decided principally
that the taxpayer had already begun development of the land in question and had to capitalize
related development costs even though the land had not been physically changed. In the court's
review of the legislative history of Sec. 263A, it observed that Congress intended the term "produce"
to be broadly construed. Further, Congress expected the uniform capitalization rules to be applied
from the acquisition of property, through the time of production, until the time of disposition.
Also, in examination of Sec. 263A(f) (which provides a narrow exception under which a particular
category of indirect production costs (namely, interest) does not have to be capitalized until the
production period begins), the court strengthened its position, concluding there would be no need
for this exception if capitalization were never meant to apply until taxpayers actually started the
production process. Therefore, if Congress intended for Sec. 263A to imply that no costs were to be
capitalized until the beginning of the production period, the codification of Sec. 263A(f)(1)(A) would
have been unnecessary.
The Reichel decision solidifies the IRS's position that developers must capitalize real estate taxes
paid on undeveloped land from the date of purchase. It provides additional firepower for existing
and future audit-related adjustments to Sec. 263A calculations of developers, as the hazards of
litigation are tilted further in the Service's favor, reducing the chance of receiving favorable
settlements at the appeals level. The only window of opportunity to expense real estate taxes
currently would be if property were not held for production and, at the time the costs are incurred, it
was not reasonably likely that production would occur at some future date. Developers should keep
the Sec. 263A rules in mind when planning their cash-flows, especially in the early phases when cash
is tight.
FROM MICHAEL R. SCHUTH, CPA, OAK BROOK, IL, AND GREGORY A. STUMP, CPA, ELKHART, IN
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