Tax Planning for the Developer:
Allocating Costs Among Land and Improvements
Published in the Journal of Taxation, December 2005
By Jerry S. Williford and C. Todd Sinnett
JERRY S. WILLIFORD, CPA, is an Executive Director with
Grant Thornton, LLP in Charlotte, North Carolina. He is
also an attorney, and is a member of the firm’s national real
estate group. C. TODD SINNETT, CPA, is a manager with
Grant Thornton in the Charlotte office, and practices in the
real estate and partnership areas.
Copyright © 2005, Jerry S. Williford and C. Todd Sinnett.
Tax Planning for the Developer: Allocating Costs Among Land and Improvements
When a developer subdivides a tract into lots, the cost basis
cannot be simply apportioned ratably to each lot unless each
has identical characteristics and relative value—an almost
impossible condition for real estate. More allocation problems
arise with respect to the cost of improvements, both currently
incurred and anticipated. Code provisions, Regulations, and
many cases provide guidance with respect to what may be
respected as an “equitable apportionment.”
When a developer acquires a tract of land and intends to
dispose of it in parcels over time, the cost of the land must be
allocated to each parcel in order to determine the basis of the
parcels sold. In addition, the developer is faced with how to
handle the cost of improvements and anticipated improvements
on the property, such as streets, sewers, utilities, etc. Proper
allocation is important not only for determining gain or loss
for income tax purposes on disposition of the parcels, but
also—and perhaps even more important—for determining and
projecting cash flow. Thus, the proper allocation of the costs
among the parcels becomes, or should become, one of the more
important issues facing a land developer. 1
This article will focus on land acquisition costs, methods for
allocation, current improvement costs, future improvement
costs, and other considerations. 2
The Service and the courts require that for tax purposes the cost
of acquiring land be equitably apportioned among the various
parcels or lots. Several methods are available for making such
allocation, some of which are specifically permitted. Others,
although not specially permitted, appear to be reasonable. In
addition, the cost of improvements, both current and future,
may be allocated among these parcels or lots using the same
method used for allocating the land cost. Developers should be
careful in selecting a method as it may be considered a method
of accounting that generally can be changed only with IRS
consent. Developers also should consider the methods that may
be used for financial statement treatment, which may or may
not be the same as the method used for tax purposes.
Land Acquisition Cost
The developer’s first concern is to anticipate that most, if not
all, costs associated with the acquisition of the land will have
to be capitalized rather than be currently expensed. To the
developer, the land most likely will be property held for sale,
as opposed to property held for investment or used in the
developer’s business.In such event, the profit generally will be
taxed as ordinary income. On the other hand, the developer
could hold onto some portion of the property for investment
2
purposes and dispose of it in the future. Any profit would then
be taxed as capital gain. 3
Historically, taxpayers engaged in the real estate business
have not been permitted to inventory real estate held for sale
to customers. 4 The Regulations applicable to inventories refer
to “merchandise” and real estate has been held not to be
“merchandise.” 5 Thus, although real estate may be held for sale
to customers, it is technically not “inventory.” The developer
is required to determine the cost of each piece of property sold,
i.e., specific identification. Therefore, a taxpayer cannot use the
LIFO or lower of cost or market methods for real estate.
The property nevertheless is still subject to the rules of
Section 263A , “Capitalization and inclusion in inventory costs
of certain expenses.” The rules of Section 263A apply to real
or personal property “produced” by the taxpayer. Under
Section 263A(g)(1) , property is produced by a taxpayer if
it is constructed, built, installed, manufactured, developed, or
improved by the taxpayer. Thus, most costs, including “hard”
and “soft” costs associated with the purchase and improvement
of the property, must be capitalized.
While Section 263A is often referred to when citing authority
to capitalize costs, other sections of the Code and Regulations
illustrate this requirement as well. Section 1012 touches on this
concept in the most basic sense. Section 1016 addresses adjustments to basis, again in the most basic sense. The Regulations
under Section 1016 give examples of adjustment to cost basis. In
one such example, real property is acquired, improvements are
made, and the cost of the improvements is added to the cost
basis of the real property. 6 The example intentionally avoids
addressing the issue of allocation, however. Although Section
1016 and its accompanying Regulations address costs to be capitalized, the treatment is by no means as comprehensive as in
Section 263A and its Regulations.
Some of the more common costs incurred with the acquisition
of land that must be capitalized are legal fees, title policies, surveys, commissions, environmental and geological studies, and
zoning variances.7 Even property taxes have to be capitalized if
at the time the taxes are incurred, it is “reasonably likely” that
the property will be subsequently developed.8
Interest also is a cost that must be capitalized. The interest rules,
in Section 263A(f), are complicated and require capitalization
under the “avoided cost” method. Under this method, the
amount of interest to be capitalized is the sum of interest
directly traceable to the construction indebtedness plus any
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Tax Planning for the Developer: Allocating Costs Among Land and Improvements
3
interest expense during the construction period that could have
been avoided if funds had not been expended for construction.
or claims are in conflict.” Obviously, as to real estate, the “two
persons” are the developer and the IRS.
Land preparation costs that are considered physical production
activities, such as grading and excavation, have to be
capitalized.9 Also, the cost to demolish a structure on the property acquired must be capitalized to the cost of the land.10 Even
expenses of the seller paid for by the developer in connection
with the acquisition of the property, such as interest, taxes, etc.,
must be capitalized.11
The equitable apportionment requirement goes back many
years. In 1927, the Board of Tax Appeals was faced with the
allocation of the cost of a tract among parts sold. 15 The Board
accepted the Service’s allocation based on the assessed valuation
of the lots. It noted that the Regulations provided for a method
of determining the gain realized from the sale of a lot of land
which is a part of a tract purchased for subdivision purposes.
The Board later said these Regulations recognized the equitable
apportionment method, and according to the Board, this was
construed by the Service as not restricted to a ratable apportionment. 16
Requirement of Equitable Apportionment
Once the hard and soft costs of the property that must be capitalized have been determined, the developer must apportion the
total cost among the parcels. Reg. 1.61-6(a) states that “[w]hen a
part of a larger property is sold, the cost or other basis of the
entire property shall be equitably apportioned among the several parts, and the gain realized or loss sustained on the part of
the entire property sold is the difference between the selling
price and the cost or other basis allocated to such part” (emphasis added).12 Although the developer may want to defer the gain
or loss until the entire property has been disposed of, Reg. 1.616(a) clearly provides that the taxpayer may not do so.13 The
Regulation provides the following examples:
Example: A, a dealer in real estate, acquires a ten-acre tract for
$10,000, which he divides into 20 lots. The $10,000 cost must be
equitably apportioned among the lots so that on the sale of
each, A can determine his taxable gain or deductible loss.
Example: B purchases for $25,000 property consisting of a used
car lot and adjoining filling station. At that time, the FMV of
the filling station is $15,000 and the FMV of the used car lot is
$10,000. Five years later, B sells the filling station for $20,000
when $2,000 has been properly allowed as depreciation thereon.
B’s gain on this sale is $7,000, the excess of the selling price of
the filling station over the portion of the cost equitably allocable
to the filling station at the time of purchase reduced by the
depreciation properly allowed.
Unfortunately, the Regulations provide no other guidance as to
what “equitably apportioned” means or how it is to be determined. 14 Black’s Law Dictionary states with regard to the term
“equity”: “In its broadest and most general signification, this
term denotes the spirit and the habit of fairness, justness, and
right dealing which would regulate the intercourse of men with
men,—the rule of doing to all other as we desire them to do to
us.” And also, “[i]n a more restricted sense, the word denotes
equal and impartial justice as between two persons whose rights
The Regulations under the 1939 Code provided the following:
“If a tract of land is purchased with a view to dividing it into
lots or parcels of ground to be sold as such, the cost or other
basis shall be equitably apportioned to the several lots or parcels
and made a matter of record on the books of the taxpayer, to
the end that any gain derived from the sale of any such lots or
parcels which constitutes taxable income may be returned as
income for the year in which the sale is made. This rule contemplates that there will be gain or loss on every lot or parcel sold,
and not that the capital in the entire tract may be recovered
before any taxable income shall be returned. The sale of each lot
or parcel will be treated as a separate transaction, and gain or
loss computed accordingly.” 17
The requirement that the cost be equitably apportioned also
applies to condominium units 18 and to cemetery lots. 19 In addition, the concept applies when land and building are purchased
together. For depreciation purposes, the cost must be allocated
between the land and the building. Reg. 1.167(a)-5 provides that
in connection with such an acquisition, the basis for depreciation cannot exceed an amount that bears the same proportion to
the lump sum as the value of the depreciable property at the
time of acquisition bears to the value of the entire property at
that time.
Also, an allocation provided in a purchase-and-sale agreement is
not acceptable—even where the parties are not related—unless
the allocation has an economic impact on both. 20 This is unlike
other situations where the IRS generally will accept agreements
among unrelated parties, such as in connection with the valuation of property for purposes of partnership allocations 21 and
the transfer of assets of a business. 22
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Tax Planning for the Developer: Allocating Costs Among Land and Improvements
Time of Allocation
In requiring the cost to be equitably apportioned, Reg. 1.61-6(a)
does not say when this determination is made. The courts have
required that the allocation be made at the time of acquisition.
When a taxpayer argued for a later date in allocating the cost,
the Tax Court agreed with the Service that the taxpayer’s
“method of allocating the basis of undeveloped land to individual lots is not logical because numerous factors may enter into
the picture between the time the land is purchased and the last
lot is sold which might increase or decrease selling prices,
whereas the basis must be allocated to the various lots as of the
date the land was acquired.” 23
In one case, the Tax Court found that at the time of acquisition
a northern tract did not have a higher per-acre value than a
southern tract even though there was some testimony to that
effect, based on its “superior topography that might render it
more valuable at later time when it could profitably be opened
for development.” 24
For depreciation purposes, when land and building are
acquired, Reg. 1.167(a)-5 is clear that the determination is made
“at the time of acquisition.” 25
While the timing of cost allocation is deemed to bear on the
accuracy and reliability of the cost allocation, moving too
hastily could prove burdensome to the developer in future
years—especially since a taxpayer may establish an accounting
method with regards to land cost allocation. Once a taxpayer
establishes a pattern of consistent treatment with regards to any
material item, a method of accounting for that item is established. 26
The Service generally takes the position that a taxpayer has
adopted a method of accounting after the taxpayer has used that
method once. 27 The IRS also takes the position, however, that a
taxpayer does not adopt an erroneous or impermissible method
of accounting until the taxpayer uses that method on two consecutive tax returns. 28
Once a method of accounting is adopted, the taxpayer must
acquire the Service’s consent in order to change that method for
that item. 29 Under several Revenue Procedures, IRS consent can
be accomplished in one of two ways, (1) requesting permission
from the Service to change the previously adopted method, or
(2) qualifying for automatic consent. 30 The Procedures covering
automatic consent address the Section 263A capitalization rules,
4
but they are very specific as to the inventory cost capitalization
methods that they are targeting and they do not apply to real
estate. Therefore, automatic consent is not currently an option
for purposes of changing an adopted method of land cost allocation, and permission to change from the taxpayer’s previously
adopted method must be requested from the IRS.
When requesting a change in the method of accounting, the taxpayer must be able to prove to the Service that the requested
method change is a change to a method that clearly reflects
income. 31 To avoid second-guessing and the painful and potentially futile process of requesting a method change for allocation
of land costs, developers should initially invest the necessary
time and effort to determine an efficient method of land cost
allocation that they wish to adopt.
Methods for Allocation
The general rule of thumb is that costs cannot be allocated ratably. There are other acceptable methods, however, including
the FMV method, the sales price method, and the discounted
present value method. 32
Ratable Method
Clearly “equitably apportioned” does not mean “ratable,” i.e.,
dividing the total cost by the number of acre or units. As stated
in one treatise: “The word ‘equitably’ as used in the Regulations, does not mean ‘ratably’ where a taxpayer purchases land
containing parcels so varied in character that he would not pay
the same price for the poorer parcels as he would for the better
parcels, he will be permitted or required to show by competent
evidence the actual proportion of the cost of the entire tract
which is properly allocable to the portion sold. In other words,
cost should not be apportioned according to area unless the
entire area is equally valuable.” 33
The Service attempted to use the ratable method in Vaira, 52 TC
986 (1969), but the Tax Court disagreed. 34 The taxpayer owned
75 acres, 15 of which were condemned by Pennsylvania for a
highway. The Service allocated the cost according to the acreage.
The court, noting that according to the Regulations the cost
must be equitably apportioned, found that it was more realistic
to allocate 50% of the cost to the 20% condemned.
Even where a tract is acquired with the intent of keeping it,
such as constructing and operating a shopping center, but a portion subsequently is sold, the basis of the portion sold can be
determined based on the value of the portion sold to the total
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Tax Planning for the Developer: Allocating Costs Among Land and Improvements
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value. In Beaver Dam Coal Company, 19 AFTR 2d 338 , 370
F2d 414 , 67-1 USTC ¶9143 (CA-6, 1966), the Service argued
that in such a situation, no portion of the tract had a value
greater than that of any other portion. The Sixth Circuit did not
agree, however. 35
Sometimes a developer will use the projected functional use of
the property to determine the relative value. This concept relies
on the assumption that the value of land in a large tract development will depend on its use. For example, in some areas commercial land may have a greater value than residential land.
Nevertheless, the cost of the whole can be allocated among the
parts if no evidence exists to suggest that the value of the parts
are different. In Byram, TC Memo 1975-135 , PH TCM
¶75135, the Tax Court allowed the Service to apply a ratable
apportionment because the taxpayer failed to present sufficient
evidence that the apportionment should be made any other way.
The taxpayer did show that one part had a particular value in
excess of the others, as it was encumbered by a lease, but the
court noted that the taxpayer had placed the lease on the property. That is, it did not exist at the time of acquisition.
Value of the separate parcels is based on a number of factors,
such as topography, geology, location, desirable features, access,
and natural landscape. As noted above, in determining the values, the burden is on the taxpayer. 37 In one case, the Tax Court
said “weight must be given to the opinions of real estate dealers
who are familiar with market values of property in the area
involved.” 38 The Tax Court also has stated, however, that valuation of property is an “inexact science, and if not settled by the
parties is capable of resolution by the Court only through
‘Solomon-like’ pronouncements.” 39
FMV Method
In Byram, the Fifth Circuit said, in agreeing with the government’s allocation, that what the taxpayer should have shown,
but never did, was the “fair market value of the tract sold” for
purposes of allocating cost basis. Therefore, if the developer
uses the FMV method, the developer must be prepared to offer
evidence, preferably through third-party appraisers and other
experts, to support the values used.
The most common method of allocating costs is the FMV
method. Example 2 in Reg. 1.61-6(a) allocates the two parcels in
the example based on the FMV of each parcel. The burden is on
the developer to support the relative values.
If several adjacent tracts are acquired at one time or within a
very short time, the price paid for each tract may not reflect the
value of the tract as a whole, or even portions of the tract, due
to the negotiations with each seller. For example, suppose in
year 1, the developer acquires one-acre tract A from seller X for
$10,000. In year 2, the developer acquires one-acre adjacent
tract B from seller Y, but for $15,000. Y has become aware of
the need for the developer to have both tracts.
In making an allocation between tracts A and B for the total
cost of $25,000 for the two acres, the taxpayer may be able to
use the assessed valuation for tax purposes. In Medlin, TC
Memo 2003-224 , RIA TC Memo ¶2003-224 , the Tax Court
said that it did not consider the amount for which property was
assessed for purposes of local taxation as a reliable criterion to
be used in estimating its FMV. The court did say, however, that
in appropriate circumstances tax-assessed value can be useful as
a guideline or as corroboration of other evidence of value.
Moreover, the Tax Court said that in dealing with relative values
of several parts of a larger tract, local tax assessments may be
relied on to provide the correct value of a particular parcel. 36
The Service stated in Ltr. Rul. 9110001 that in connection with
the allocation of the cost between land and building, the
assessed values of the land and the building may not be used
when better evidence exists.
Gross Profit Method
Under the gross profit method, the developer accumulates the
cost of the land and the improvements into a pool, and as lots
are sold, costs are allocated as a gross profit or gross margin
percentage of the actual selling price.
When applying this method, the taxpayer must first calculate
the cost of the property available for sale by adding land,
improvements, and properly capitalized expenses into one pool.
Next, an estimate of the gross margin is determined that is reasonable, taking into account all pertinent factors such as industry, location, market conditions, comparables, etc. The profit
margin component of this method is the primary factor in the
determination of the estimate of cost allocation. After an appropriate gross margin estimate is determined, that margin estimate
is applied to the actual sales proceeds received for the year. This
margin dollar amount is then subtracted from the total proceeds
received for the year in order to determine the cost of real property sold. This cost is then subtracted from the total cost pool
to determine the capitalized cost of real property remaining at
the end of the year. See Exhibit 1 for an example of how this
method operates.
Grant Thornton, LLP
Tax Planning for the Developer: Allocating Costs Among Land and Improvements
Exhibit 1.Example of Gross Profit Method
Beginning land cost
Improvements and capitalized
expenditures at cost
Less estimated cost
of land sold: Actual sales
at selling price
Less estimated gross
margin of 15%
Estimated cost of land
sold for the year
Estimated ending carrying
cost of land
$1,000,000
$500,000
$1,500,000
$600,000
$90,000
$510,000
$990,000
This method actually allocates the cost of the land at the time of
sale rather than at the time of acquisition, which as discussed
earlier, is required by the courts. Nevertheless, this method does
appear to be a reasonable equitable apportionment method
under Reg. 1.61-6(a) . 40
If certain lots require unusual expenditures, however, the use of
the gross profit method can be disadvantageous. The additional
expenditures will be capitalized into the total cost pool and on
the up-front sale of those lots that required the additional
expenditures, the taxpayer will be forced to recognize a profit
margin in excess of the actual margin realized. Another disadvantage of this method is that cost allocation is not made at the
time of the acquisition and thus may not be technically correct.
Sales Price Method
Real estate appraisers often use what is called the “gross sale-out
value” or the “gross retail value.” This method allocates the cost
among the parcels in the proportion that the expected selling
price of each lot bears to the total expected price. This method
is used assuming all, or substantially all, the infrastructure is in
place or can be reasonably estimated. If the sales are expected to
occur over time, then the values are discounted to present value.
In Clayton, 52 AFTR 599 , 245 F2d 238 (CA-6, 1957), aff’g TC
Memo 1956-21 , PH TCM ¶56021 , the parcel in question
fronted on two streets. The Sixth Circuit agreed with the Service that the cost of a parcel was allocable among the lots based
on the selling price of the lots. The taxpayer, acting as his own
witness, argued that the cost should be allocated 90% to the lots
facing one street and 10% to the lots facing the other street. The
IRS argued, and the Sixth Circuit agreed, that a 65%/35% allo-
6
cation was reasonable based on the selling price, because nothing had occurred from the date of purchase altering the relative
values of the frontage.
Accordingly, the selling price method may be limited to situations where nothing occurs to change the relative values of the
parcels between the date of acquisition and the date of sale.
While this method was applied by the Service and accepted by
the Sixth Circuit in Clayton, other courts have stated that this
method is not logical. 41 The reasoning is that this method relies
on all factors staying constant, such as the ratio of value to basis
over time, and the capitalization of costs for improvement and
other expenses. Additionally, in order to support the reasonableness of this method, the taxpayer’s actual selling price
would have to practically mirror the previously estimated selling price—otherwise, the IRS would be able to use Clayton as
precedent for reallocating the cost to match the actual selling
price.
One potential option would be to limit use of the sales price
method to real property sales transaction that can take place
within a two-year period. This would allow the taxpayers to
play “Monday morning quarterback” and allocate the cost basis
on their prior year extended tax return to match the allocation
on their current year tax return.
(In Notice 2005-14, 2005-7 IRB 498 , addressing the new Section 199 domestic production activities deduction, the IRS took
the position that if 95% of the gross receipts derived by the taxpayer from a construction project are attributable to real property as defined in Reg. 1.263A-8(c) , the total gross receipts
derived by the taxpayer from the project are domestic production gross receipts from construction (assuming all other
requirements of Section 199 are met). Therefore, these receipts
may be eligible for the additional deduction. 42 One could argue
that deductions for certain qualifying property should deviate
from a gross profit allocation for various reasons. Nevertheless,
a one-size-fits-all approach is being applied in this Notice. Congress clearly intended that the production activities deduction
be an incentive and not an allocation of cost basis, but the
method still would have to be considered equitable. It is comforting for taxpayers, however, that government is using gross
profits as a base for equitable allocation.)
Discounted Present Value Method
Another method that is used by developers involves present
value concepts. The discounted present value method recognizes the time value of money along with the risk factor of a
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Tax Planning for the Developer: Allocating Costs Among Land and Improvements
subdivision development. As in any situation, the rate used by
the developer will depend on the rate of earnings on the capital
of the developer and the risk factor.
This method is not specifically authorized by the Code or Regulations but it appears to be a reasonable method and thus
should be accepted by the courts. 43 Discounting is a technique
that can be used only in conjunction with the units, area, square
footage, or relative value cost allocation method (see “Financial
Accounting,” below). The basic theory is that the sooner a parcel is developed and sold, the sooner these proceeds can be reinvested. Financial resources and market conditions generally
prevent the development of the entire project at one time.
Therefore, since the earlier-developed parcels help finance the
later ones, the cash flow generated from the first sales is more
valuable and should be shielded by a greater portion of the land
cost. The result represents a constructive accounting technique
that recognizes the time value of money and the inherent risk
factor in normal tract development.
IRS Audit Handbook
At one time the IRS had an Audit Handbook specifically
directed at the real estate industry. 44 This Handbook said that a
pro rata allocation of land costs may or may not be proper. Particular attention was given to the cost allocated to parcels transferred to related companies and stockholders, or parcels set
aside for future use. The Handbook told agents that the taxpayer most likely had a revenue/cost analysis that was undertaken before the decision was made to develop the land. The
agent was also told that for financial reporting, both management and the outside accountants would have allocated development costs based on relative sales estimates. But, it said, the
agent may find that for tax purposes the costs were being allocated based on the number of lots or some other area measurement.
Regarding the method of allocating the costs of the lots, the
Handbook stated that some method of allocation must be
worked out to “fairly apportion” these costs to the individual
lots. The usual allocations, according to the Handbook, are
made as follows:
(1) Division of costs by the number of lots.
7
(4) Division of costs based on selling prices.
The Handbook explained that regardless of the method used, it
was important for the agent to determine if the chosen method
was “equitable and gives a fair result based upon the values of
the lots upon completion of development.” The Handbook
went on to say that it had been found that a division of costs
based on selling prices was more desirable and equitable than
the other methods because under this method the costs were
more accurately matched to the anticipated income from the
properties.
The IRS made the following, but not surprising, statement:
“There is a tendency [for the developer] to overallocate costs to
residential development in the early years and underallocate
costs to commercial development in the later years.” As if a
developer would consider such thing!
The Service does have a current training course entitled “Valuation Training for Appeals Officers” that contains a large section
on the valuation of real estate. 45 This material does not specifically address land and improvement cost allocation by developers, but it does provide useful information as to how the IRS
approaches real estate valuations. Not surprising, the material
emphasizes that there are three important factors to consider in
today’s world concerning the valuation of real estate:
(1) Hazardous materials.
(2) Wetlands laws.
(3) Endangered species.
Regarding the various methods of valuation, the material states
that “it is not sufficient to view the property from one’s car,
which is known as a ‘windshield’ appraisal.”
Financial Accounting
The cost allocation issues that developers have to deal with for
tax purposes are also issues for financial accounting purposes
under generally accepted accounting principles (GAAP). As
expected, the accounting rules attempt to match costs with revenues, sometimes unlike the tax rules. The accounting rules provide for the following methods:
(2) Division of costs by the front footage on one or more
streets.
Specific identification.
(3) Division of costs by area.
Relative value based on fair value or sales value.
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Tax Planning for the Developer: Allocating Costs Among Land and Improvements
Unit or area.
Gross profit. 46
The specific identification method is generally not practical for
allocating the cost of a large tract that will be divided into small
tracts. It would apply, however, to several tracts bought at different prices, particularly when the tracts are not related to each
other.
The relative value method provides that land costs and all common costs incurred prior to construction should be allocated
based on the relative fair value of each land parcel before construction. Construction costs should be allocated on the basis of
the relative sales values of each unit. When this method is used,
consideration must to be given to the surface of the land, the
geology, desirable features, aesthetics, elevation, and proximity
to various improvements. Anticipated selling prices of the lots is
one way developers establish relative fair values. This method
takes into account unusable land.
The unit or area method allocates costs based on the number of
units in the total. This method is recommended only where the
value of each unit is about the same. It is similar to the pro rata
method for tax purposes, which is unacceptable in most situations.
The gross profit method is a variation of the relative value
method. It allocates the cost to units sold so all sales have the
same gross profit. Under this method, the cost of sales percentage is determined by dividing the total estimated cost by the
total estimated sales value.
8
clearly reflects income. A taxpayer also may be able to argue
that a GAAP-based method is a reasonable method in accordance with Regulations covering Section 263A. 48 Additionally, if
a GAAP method is used, there will not be a book-to-tax difference if the taxpayer computes book income on a GAAP basis.
Current Improvement Costs
Improvements made to land should be allocated to the different
lots or parcels. In Rev. Rul. 68-478, 1968-2 C.B. 330 , the IRS
clearly stated that “[i]f a person engaged in the business of
developing and exploiting a real estate subdivision constructs a
facility thereon for the basic purposes of inducing people to buy
lots therein, the cost of such construction is properly a part of
the cost basis of the lots, even though the subdivider retains tenuous rights, without practical value, to the facility constructed
(such as contingent reversion).” Typical improvements include
land preparation, streets, water and sewer lines, recreation facilities, and fences. The cost of such improvements must be allocated if they benefit all of the lots or parcels.
In Homes By Ayres, 58 AFTR 2d 86-5493 , 795 F2d 832 (CA-9,
1986), aff’g TC Memo 1984-475 , PH TCM ¶84475 , the Ninth
Circuit, without citing any authority, listed three acceptable
methods for home builders to use in allocating a pool of capitalized costs: the relative sales value method, the average cost
method, and the square footage method. 49 Ayres involved a
tract home builder who incurred direct costs such as labor
materials and permits, and indirect costs such as overhead, payroll, taxes, and vehicle operation costs.
These financial accounting rules are somewhat similar to the tax
allocation rules. In Urbanek, 53 AFTR 2d 84-1191 , 731 F2d
870 (CA-F.C., 1984), the Federal Circuit cited three accounting
texts in support of the allocation method used by the Service. 47
If, however, a developer were to use these accounting rules for
tax purposes, the question that must be satisfied would be
whether these financial allocation methods result in an “equitable apportionment” as required under Reg. 1.61-6(a) .
According to the Ninth Circuit, the relative sales value method
determines the cost of houses sold by multiplying total capitalized costs (those already incurred plus estimated cost of completion) by the ratio of the selling prices of the houses sold to
the estimated selling prices of all houses in the phase. The average cost method determines the cost of houses by multiplying
total capitalized costs by the ratio of the total number of houses
sold to the aggregate number of houses to be sold in a phase.
The square footage method determines the cost of houses by
multiplying total capitalized costs by the ratio of the aggregate
square footage of houses sold to the aggregate square footage of
all houses to be sold in a phase. The court noted that all three
methods comported with GAAP at the time and that the Service admitted that these methods accurately reflected income.
An argument could be made in accordance with Reg. 1.4461(a)(2) that the method chosen is “a method of accounting
which reflects the consistent application of generally accepted
accounting principles” that should be respected provided it
If an improvement made on one parcel only incidentally benefits the other parcels, the cost can be allocated solely to the parcel on which the improvement was made. In Keeler, 3 AFTR 2d
1292 , 174 F Supp 69 (DC Ga., 1959), a fence was built by the
The accounting rules do not prevent the use of hybrid methods
combining the above allocation methods.
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Tax Planning for the Developer: Allocating Costs Among Land and Improvements
taxpayer separating property retained and property subdivided
into lots for sale. The taxpayer attempted to allocate a portion
of the cost of the fence to the lots sold. The court noted, however, that the fence was built on the property retained and did
not directly benefit the lot owners. According to the Court, the
result would have been different if the fence had been built on
the property line and if in some manner the other lot owners
had been given the right to use the fence.
Even where improvements are required to be made to all of a
tract in order to obtain improvements for only certain lots to be
sold, the total cost of the improvements must be allocated
among all of the lots. In Dahling, TC Memo 1988-430 , PH
TCM ¶88430 , the developer owned a tract that he wanted to
subdivide into lots. In order to obtain necessary permits, he
submitted plans to the city showing the land divided into six
lots with a street down the middle. He built the street and made
other common improvements. He sold three lots and allocated
the costs of the improvements to these lots on the theory that
the value was in the first three lots and the improvements were
made only for the purpose of selling the three lots. The Tax
Court disagreed and required that the cost be allocated to all
six. The developer argued that he would not be able to recover
the cost of the improvements unless they were allocated to the
three lots because the other lots retained had little value. The
unsympathetic Tax Court noted that he would just have a loss
on the other three lots. To add insult to injury, the court said
that such loss would be due to “an error in his business judgment.”
In the discussions above, it has been assumed, and rightfully so,
that the costs to be allocated include the cost of improvements
on the land. Nevertheless, in the past the Service has challenged
the inclusion of the cost of certain improvements in the properties sold. In Willow Terrace Development Co., Inc., 15 AFTR
2d 1108 , 345 F2d 933 (CA-5, 1965), aff’g 40 TC 689 (1963), the
developer included the cost of water and sewer systems in the
basis of the lots sold. The Service argued that these facilities
could be included in the cost of the lots only if they were constructed in order to sell the lots and were permanently and
irrevocably dedicated to the lot owners so that the cost was
recoverable in no other manner. According to the IRS, the facilities were a separate investment and were to be retained by the
developer rather than being dedicated to the homeowners. The
developer actually sold the facilities to the municipality in the
year after those in issue before the Fifth Circuit. The circuit
court found that pursuant to FHA requirements, the developer
transferred a trust deed giving title to a trustee for the benefit of
9
the property owners. Thus, the developer was allowed to
include the cost of these facilities in the basis of the lots because
the primary purpose for constructing the facilities was to sell
the lots and the developer did not retain title to the facilities.
In Estate of Collins, 31 TC 238 (1958), the developer included
the cost of a sewage disposal system in the cost basis of lots
sold. The Service challenged this treatment because the developer had not given up title to the system and continued to operate the system. 50 The Tax Court disagreed, and allowed the cost
of the system to be included.
The court reviewed the cases relied on by the Service and concluded that “if a person engaged in the business of developing
and exploiting a real estate subdivision constructs a facility
thereon for the basic purpose of inducing people to buy lots
therein, the cost of such construction is properly a part of the
cost basis of the lots, even though the subdivider retains tenuous rights without practical value to the facility constructed
(such as a contingent reversion), but if the subdivider retains
‘full ownership and control’ of the facility and does ‘not part
with the property [i.e., the facility constructed] for the benefit
of the subdivision lots,’ then the cost of such facility is not
properly a part of the cost basis of the lots.” The court in
Collins found that the developer retained only an unprofitable
right to operate the system for the benefit of the owners and a
reversionary interest contingent on a remote possibility. Thus,
the developer was allowed to include the cost in the basis of the
lots.
In Charlevoix Country Club, Inc., 86 AFTR 2d 2000-5061 , 105
F Supp 2d 756 (DC Mich., 2000), the court did not permit the
developer to include the cost of developing a country club and
golf course in the cost bases of adjacent lots and club memberships. The court found that the developer never transferred any
ownership interest in the course or the club to the lot purchasers. Even though the club and the course were constructed
for the sole purpose of enhancing the salability of the lots, the
costs could not be included.
Moreover, in Bryce’s Mountain Resort, Inc., TC Memo 1985293 , PH TCM ¶85293 , the Tax Court did not permit the taxpayer to include the cost of water and sewer systems in the
basis of residential lots sold. In addition to the lots developed
and sold, the taxpayer also owned recreational facilities consisting of a ski facility, golf course, tennis courts, swimming pool,
and 45-acre lake. Title to the water and sewer systems was not
transferred to the lot owners. Even though the taxpayer argued
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that the systems were not profitable and were not expected to
be profitable, the court recognized that the systems also serviced the recreational facilities and thus there was a substantial
benefit to the taxpayer apart from advancing the sale of the lots.
In Noell, 66 TC 718 (1976), the taxpayer and his partner subdivided an 85-acre tract into 68 homesites and an adjoining airport runway and two main taxiways. This allowed homeowners
to taxi their private aircraft alongside their homes. The airstrip
and related facilities were constructed to facilitate the sale of lots
within the subdivision. The question was whether the developers relinquished control and ownership of the airstrip and facilities. The agreement did not provide that the facilities would be
given over to the lot owners at some date certain, and after ten
years the property owners could be charged for use of the airport facilities. Only if any charges ultimately levied against the
lot owners, as well as the income from the airport-related commercial facilities, were not adequate to operate the facilities on a
economically feasible basis, would the facilities be donated to
the property owners.
The Tax Court found that the contractual language itself contemplated substantial independent commercial use of the land
facilities. The critical question as posed by the court was
“whether [the taxpayer] intended to hold the facilities to realize
a return on his capital from business operations, to recover his
capital from a future sale, or some combination of the two; or
whether, on the other hand, he so encumbered his property
with rights running to the property owners (regardless of who
retained nominal title) that he in substance disposed of these
facilities, intending to recover his capital, and derive a return of
his investment through the sale of the lots.” The Tax Court
determined that the cost of the airstrip could not be included in
the cost of the lots because of retained ownership. In doing so,
the court noted that the landing strip was not surrounded by
the lots. All of the lots were on one side of the strip, and, while
connected to the facilities by a series of taxiways, the airstrip
could nevertheless be owned and used as a separate income-generating activity separate from the sale of the lots.
Norwest Corp., 111 TC 105 (1998), addressed the allocation of
the cost of a common improvement—an atrium—among properties that adjoined it and benefited from it. 51 The taxpayer, a
bank, owned several properties on three adjacent blocks. The
Tax Court held that the cost could not be allocated. The court
pointed out that if the taxpayer could show that it (1) had constructed the atrium with the basic purpose of inducing sales of
its adjoining properties, and (2) had not retained full ownership
10
and control of the atrium, then the cost could be added to the
basis of the adjoining properties. The taxpayer, however, had
failed to prove that when it considered the atrium it had plans
to sell any of the adjoining properties. The Tax Court found
that the purpose of the atrium was to address certain design
issues and to enhance the bank’s image.
The bank relied on a series of decisions that the Tax Court
called the “developer line of cases.” 52 These cases involved real
estate developers who sought to allocate the cost of common
improvements to the bases of residential lots held for sale.
According to the Tax Court, in order to allocate the costs, the
purpose of the improvements must be to induce sales and the
taxpayer does not retain “too much control” of the improvement. In Norwest, the IRS argued that the developer line of
cases were limited to developers of residential lots and were not
applicable to the bank’s commercial property. The Tax Court
disagreed.
The developer line of cases appear to be “codified” somewhat in
the Regulations under the uniform capitalization rules of Section 263A dealing with the capitalization of interest and other
costs. Under Reg. 1.263A-10(b)(1) , a unit of property includes
any components of real property that are functionally interdependent and “an allocable share of any common feature owned
by the taxpayer” even though the common feature does not
meet the functional interdependence test.
Reg. 1.263A-10(b)(6), Example 3 , involves a taxpayer in the
business of developing commercial property. On a 20-acre tract,
the developer intends to build a shopping center with 150 stores
and a 1,500-car parking lot that will not be held for the production of income. The stores will be leased. The shopping center is
to be completed in phases. According to the example, each store
is part of a separate unit of real property and the parking lot is a
common feature benefitting each store. Thus, the developer
must include an allocable share of the parking lot cost in each
store unit. The example states that the portion of the parking lot
that is allocated is determined using “a reasonable method of
allocation.”
In Reg. 1.263A-10(b)(6), Example 4 , a real estate developer
begins to construct a condominium building and a convenience
store for the benefit of the condominium. The developer
intends to separately lease the store. The example asserts that
even though the store benefits the condominium units, the store
is not a common feature because the developer will retain it and
lease it.
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Tax Planning for the Developer: Allocating Costs Among Land and Improvements
In conclusion, it is clear that current improvement costs, such as
land preparation, streets, etc., are allocable to the various parcels
or lots that these costs benefit, and not just to the portion of the
land on which the improvements are made, unless there is only
incidental benefit to the other parcels or lots. If, however, the
developer retains ownership and control of the improvements,
the cost of such improvements cannot be allocated to the
parcels sold. In allocating the cost of improvements, developers
can employ the same allocation methods used for land costs.
Future Development Costs
In addition to allocating the land costs and current improvements to the various individual tracts or lots to be sold, the
developer should allocate the estimated future costs of improvements to the property that will benefit the lots to be sold. Often
lots may be sold before these improvements are made. In order
to properly match revenue and costs, these sold lots should bear
some portion of the future costs that will benefit these lots.
Examples of future improvements include streets, sewers, parks,
common areas, swimming pools, tennis courts, etc., that generally are not constructed until later in the development, and
sometimes not until the final phase.
Economic Performance Test
For purposes of accruing generally any liability for both
expenses and capital expenditures, the Regulations require that
the “all events” test be met establishing the fact of the liability
and the amount of the liability. 53 In addition, Section 461(h)
requires that “economic performance” has occurred. While economic performance does not occur until services or property
are provided to the taxpayer, the Code contains an exception for
“recurring items” that are paid no later than 81/2 months after
the end of the year. This exception typically will not apply to
the major costs incurred by developers relating to the land to be
developed. Generally the all events test and the economic performance rules are thought of in the context of deductions for
expenses, but they apply equally to the capitalization of costs. 54
Rev. Proc. 75-25, 1975-1 CB 720 , had allowed the inclusion of
future costs under certain conditions. In June 1990, Treasury
issued Proposed Regulations under Section 461(h), six years
after its enactment. In the Preamble to these Proposed Regulations, Treasury made the following statement: “Finally, because
economic performance must occur in order for a liability to be
taken into account, the estimated cost of future improvements
to subdivided real estate may not be added to the basis of lots
11
sold if economic performance has not occurred with respect to
those costs. Therefore, the statute and regulations override Rev.
Proc. 75-25....”
Thus, without any direct instructions from Congress, Treasury
revoked a rule that had been around for years and which permitted developers to include in the basis of their land the estimated costs of future developments. Strong objections from
developers and tax practitioners caused Treasury and the IRS to
backtrack. Notice 91-4, 1991-1 CB 315 , concluded that Rev.
Rul. 75-25 would remain in effect until the issuance of further
rules under Section 461(h) . 55
The 1992 Procedure. The next development was the issuance of
Rev. Proc. 92-29, 1992-1 CB 748 , providing a method for
developers to obtain the Service’s automatic consent for including the cost of future improvements. 56 The method described in
the Procedure is called the “alternative cost method.” Under
this method, the basis in the tracts or lots is increased by that
property’s allocable share of the estimated cost of common
improvements without compliance with the economic performance rules of Section 461(h) .
Rev. Proc. 92-29 defines estimated costs of common improvements as the amount incurred under Section 461(h) as of the end
of the tax year, plus the cost reasonably anticipated to be
incurred under Section 461(h) during the ten succeeding tax
years (the “ten-taxable year horizon”). The cost of future
improvements committed to, but for which economic performance is deemed to occur beyond the tenth succeeding tax year,
generally cannot be allocated under the alternative cost method.
The costs to be allocated to the basis of properties sold are the
future costs relating to “common improvements.” This refers to
real or personal property that benefits more than one property
held for sale by the developer. Examples of common improvements listed in the procedure include:
Streets.
Sidewalks.
Sewer lines.
Playgrounds.
Clubhouses.
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Tax Planning for the Developer: Allocating Costs Among Land and Improvements
Tennis courts.
Swimming pools.
The developer must be “contractually obligated or required by
law to provide the common improvements” and the costs must
not be properly recovered through depreciation by the developer. 57 Although not specifically mentioned, other examples
might include golf courses, parks, and green areas.
Rev. Proc. 92-29 sets forth six conditions 58 that a taxpayer must
meet in order to use the alternative cost method:
(1) The developer must file a request with the district director.
(2) The developer must be contractually obligated, or required
by law, to provide the common improvements.
(3) The cost of common improvements must not be properly
recoverable through depreciation by the developer.
(4) The developer must sign a consent extending the period for
assessing income taxes with regard to the alternative cost
method computation until one year beyond the year in
which the project is estimated to be completed.
(5) The developer must file an annual statement for each project
using the alternative method.
(6) The developer must file a supplemental request for each
project using the alternative cost method if the project is not
completed within the time period covered by the previous
method.
Several limitations apply under the alternative cost method. For
one, the developer is limited in the total amount of actual and
future common improvement costs that can be included in the
basis of properties sold to the amount of common improvement
costs actually incurred through the current year, applying the
economic performance standard. That is, under the alternative
cost method a developer will never allocate more common costs
to the properties sold than it has actually incurred on the entire
project.
Example: A developer estimates that common improvements
will cost $20,000 per lot. The developer sells five lots in the first
year. The developer can include the $100,000 in the cost of the
five lots sold only if he actually incurs $100,000 of common
improvement costs in year 1 applying the economic perform-
12
ance rule of Section 461(h) . Thus, if the developer incurs only
$75,000 by the end of year 1, only $75,000 can be included in
the basis of the five lots sold.
The effects of this limitation are mitigated in many instances by
the fact that the cost of the land allocable to the common
improvements should constitute a Section 461(h) expenditure,
even though the improvements have not been constructed. For
example, if a developer purchased land for $1 million, all the
lots are equal in value, and the developer is contractually committed to use 15% of the land for common improvements,
$150,000 of Section 461(h) expenditures have been incurred,
notwithstanding that construction of the improvements has not
commenced.
Other limitations are that (1) the alternative cost method is to
be applied on a project-by-project basis, and (2) a developer is
not allowed to adjust a prior tax return if it is determined in a
subsequent year that the costs of common improvements allocated to properties sold are either overstated or understated.
Such adjustments are to be made in the year they are discovered.
Developers wishing to use the alternative cost method without
the ten-year horizon limitation must follow a different process.
Approval in this case is not automatic. The developer must file a
request for a private letter ruling and pay a user or filing fee.
One expense item that is not allocable under Rev. Proc. 92-29 is
interest expense. Such interest is capitalized specifically under
Section 263A(f) . 59 Therefore, a developer cannot include the
estimated future period interest expense in the estimated costs
of lots to be sold. Under Section 263A(f) , only the interest
expense paid or incurred during the construction period is to be
capitalized in the year paid or incurred.
It appears Rev. Proc. 92-29 was an issue in only one reported
case. In Hutchinson, 116 TC 172 (2001), the question was
whether the estimated cost of a clubhouse could be included in
the costs to be allocated, under the Procedure, to lots sold. The
IRS argued, and the Tax Court agreed, that the developer would
have been able to recover the costs through depreciation, a proscribed factor under Rev. Proc. 92-29 . Another issue in
Hutchinson was the treatment of interest expense. The court
held that Rev. Proc. 92-29 does not apply to interest since interest is covered by Section 263A(f) .
In FSA 200004005 , the Service concluded that a real estate
developer may allocate the cost of developing a golf course and
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Tax Planning for the Developer: Allocating Costs Among Land and Improvements
related facilities to the basis of adjacent homesites as long as the
developer has filed an election under Rev. Proc. 92-29 .
If a developer does not wish to comply with Rev. Proc. 92-29 ,
is there any support for including the costs anyway? Prior to
the enactment of Section 461(h) in 1986 and prior to Rev. Proc.
92-29 , there was some justification under case law for including
future costs in basis of current lots sold. 60 With the enactment
of Section 461(h) , however, the developer must meet the economic performance test for the future costs to be included in
the basis of the lots to be sold. Therefore, it seems that the only
option for the developer seeking to include the cost of future
improvements is to comply with Rev. Proc. 92-29 .
13
ally at different prices per acre due to different sellers and, possibly, knowledge by the sellers of sales by others in the area. In
this situation, can the costs of all the tracts be lumped together
into one pool and allocated among the lots to be sold?
In Davock, 20 TC 1075 (1953), the taxpayer’s purchase of two
contiguous parcels of land occurred several years apart. 62 The
two parcels were sold in one transaction, with one having a
short-term holding period and one long-term. The taxpayer
argued that the gain or loss should be computed separately for
each parcel by allocating the sale price. This would have given
the taxpayer a short-term loss on one parcel and a long-term
gain on the other. The IRS argued that the transaction should be
viewed as a whole, resulting in an overall long-term gain.
Financial Accounting Rules
For financial accounting purposes, cost reporting for the seller
is not a primary concern when dealing with obligations for
future development costs. The financial reporting concern
seems to be focused more on the income recognition concept.
Accordingly, FASB Statement 66 states: “Profits shall be recognized in full when real estate is sold, provided (a) the profit is
determinable, that is, the collectibility of the sales price is reasonably assured or the amount that will not be collectible can
be estimated, and (b) the earnings process is virtually complete,
that is, the seller is not obligated to perform significant activities
after the sale to earn the profit. Unless both conditions exist,
recognition of all or part of the profit shall be postponed.”
Therefore, in the situation of a land sale with contractually
agreed-to future development costs, it would seem that until the
improvements are complete the earning process has not been
satisfied. 61 Because of the significant differences between financial accounting rules and the tax rules with regard to land sales
with accompanying future development costs, significant bookto-tax differences generally exist.
Other Considerations
Other factors that come into play when cost must be allocated
between land and improvements include:
Acquisitions of land made over time.
Unusable land.
Incorrect allocations.
Acquisitions Over Several Years
Often in connection with a planned large development, the land
will be acquired in several tracts spanning several years and usu-
The Tax Court held for the taxpayer on the grounds that the
two parcels had not been “welded into a single unit.” The court
relied on Lakeside Irrigation Co., 29 AFTR 521 , 128 F2d 418
(CA-5, 1942), cert. den., which involved the basis in lots of corporate stock. There, the Fifth Circuit said: “[I]n general each
purchase is a separate unit as to which cost and sale price are to
be compared. If less than all of a purchase is sold, either a credit
on the cost of all is to be entered, or a proportion of the cost is
to be attributed to what is sold, as regulations may have prescribed. If several things separately bought are welded into
some physical or business unit, as where bricks, lumber and
hardware are made into a house, or machines and buildings are
made into a plant, and then sold together, the cost is the aggregate costs of the ingredients, and the sale price is that of the
whole, for separation would be impracticable and unreasonable.” Even though the Tax Court found that the two tracts in
Davock had not been “welded together,” it appears that if several parcels were integrated into one development, the Tax
Court might lump together the costs and allocate the total as if
the parcels had not been separately acquired at different times.
In Krahl, 9 TC 862 (1947), the taxpayer bought two properties,
each with a building, six years apart. There was no connection
between the two properties. The taxpayer acquired the second
building in order to protect the first from the contingency that
someone else might construct a new building which might damage the taxpayer’s first building. Both properties were sold to
the taxpayer’s corporation for the tax basis of the properties.
The taxpayer treated the transaction as a sale of a single property and reported no gain or loss. The Service argued that there
were two separate transactions which resulted in gain on one
and a loss on the other. Further, because of the related-party
rules the loss was not deductible. The Tax Court held for the
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IRS. The court said it was not satisfied that the taxpayer had
actually “welded” the two properties, citing Lakeside Irrigation.
When a premium is paid to obtain an undesirable tract of land
in connection with the acquisition of a desirable tract, the premium paid or the cost of the undesirable tract can be allocated
to the desired tract. In Wilson, 27 AFTR 2d 71-815 , 322 F Supp
1166 (DC Ala., 1971), the taxpayer purchased 20 acres of land in
1960 for $30,000 and the adjacent 20 acres in 1961 for $35,000.
He was forced to acquire an adjoining eight acres in 1963 at a
premium ($46,000) to link up the 40 acres. After constructing a
road and installing a water line, he sold the 40 acres for $115,000
in 1966. At the time of the sale, the FMV of the remaining seven
acres (approximately one acre was used for the road) was
$23,000. Both parties agreed on this value. The premium for the
seven acres was approximately $21,000. The total cost of the
property including the road and water line was $114,450.
The Service insisted that the premium be apportioned equally
among the eight acres and not among all of the acres, as the taxpayer contended. The court disagreed and said that under the
circumstances the cost of the “entire property,” as the term is
used in Reg. 1.61-6(a) , should be taken to be the cost of the
entire 48 acres, including the cost of the road and the water line.
Furthermore, the court said that the proper way to determine
the cost of the acreage sold was to take the acreage sold divided
by the total acreage times the total cost of the land plus the
improvements. Thus, 40/47 multiplied by $114,450 yielded an
allocated cost of $97,400. (The taxpayer had used only $91,450,
obtained by taking the total cost of $114,450 and subtracting the
$23,000 value of the seven acres retained. The court said the taxpayer’s method was not an acceptable method of equitable
apportionment, even if it produced a lower cost.)
Additionally, in Beaver Dam Coal Co., the taxpayer paid a premium price for farmland under which there was no coal in
order to acquire the right to strip acres under which coal
existed. The Sixth Circuit allowed the taxpayer to equitably
apportion the actual cost between the land overlying coal and
the remainder of the farmland. This allowed more of the cost to
be allocated to the coal, resulting in a greater depletion
allowance for the taxpayer. The circuit said that “[i]t is only
under the equitable apportionment method that [taxpayer]
recoups his actual capital investment in the coal producing
properties.”
14
other problems. In addition, the developer may be required to
set aside a portion of the property for schools, parks, etc. The
developer’s own marketing plan may call for open areas. How is
the cost of such portion of the property to be treated for tax
purposes?
In Biscayne Bay Islands Co., 23 BTA 731 (1931), the taxpayerdeveloper owned an island and developed only the lots around
the shoreline. The center of the island was not developed into
lots but was maintained as a park and recreation area. When the
developer sold the lots, the cost of the center of the island was
allocated to the cost of the lots sold. The Board of Tax Appeals
disagreed, and required that the park area carry its own cost,
based on relative value. The Board indicated that the cost of
unmarketable land can be allocated only if it is “permanently
beyond the possibility of sale and gain,” and if the cost can be
absorbed only by the other salable lots. Thus, the burden is on
the developer to show that the unused land can never be developed. There are several ways that the developer can meet this
burden.
First, the developer might consider dedicating the portion of the
land to public use. For this strategy to be successful, the government authority receiving it would have to agree. Although government donees qualify as “charities” for purposes of charitable
contribution deductions, the developer should not expect to
obtain such a deduction for the FMV of the contribution.
According to Section 170(a)(1)(A) , a charitable deduction is
limited to the tax basis of property held for sale, rather than the
value. In order to obtain a charitable deduction for the tax basis
of the property, however, the taxpayer must show that there
was a charitable or donative intent. If the gift was made in order
to enhance the developer’s project, no deduction will be
allowed. 63 Because charitable deductions are subject to other
limitations for both individuals and corporations, other ways to
handle the unused land should be considered.
Presumably, if no charitable deduction is taken for land given to
a governmental unit, a greater amount of total cost is equitably
allocated to the portions of the land that will ultimately realize
that value. This is what the taxpayer attempted to do in Biscayne Bay Islands Co. The developer must weigh the benefits of
claiming an immediate, but limited, charitable deduction for the
cost of the unused land against the benefits of allocating the cost
among the lots to be sold and getting the “deduction” over the
years of sale without any limitations.
Unusable Land
Often when a large tract of land is acquired, some portion is not
usable because of wetlands, steep slopes, soil conditions, or
Another approach the developer may consider is abandoning
the property in an attempt to receive a current deduction withGrant Thornton, LLP
Tax Planning for the Developer: Allocating Costs Among Land and Improvements
out limitations. Abandonment losses are permitted under Section 165 . The developer may encounter a problem, however, in
establishing the basis of the property abandoned. Should the
developer attempt to use the FMV, the IRS may argue that
because the property is abandoned, it is worthless and thus
should not be allocated any basis.
15
ing a method as it may be considered a method of accounting
that generally can be changed only with the consent of the Service. Developers also should consider the methods that may be
used for financial statement treatment, which may or may not
be the same as the method they use for tax.
Practice Notes
Finally, if there is any chance that the property would be useful
to someone else, even if for bird-watching, the property could
be sold to that person at possibly a loss.
Therefore, in most situations the cost of the unusable land or
the donated land will be thrown into the pool of costs to be
allocated to the cost of the remaining land, thereby reducing the
gain on the future sales.
Incorrect Allocations
What if a developer makes an allocation of the total cost of the
land to the various parcels or lots in the year of acquisition and
sells some of them, but subsequently determines that the allocation is incorrect? If the years in which the sales occurred are still
open, the developer will be required to either amend its tax
return and report the correct allocation and the gain or loss, or
request a method change if a method has been established.
While the timing of cost allocation is deemed to bear on the
accuracy and reliability of the cost allocation, moving too
hastily could prove burdensome to the developer in future
years—especially since a taxpayer may establish an accounting
method with regards to land cost allocation. Once a taxpayer
establishes a pattern of consistent treatment with regards to any
material item, a method of accounting for that item is established.
When requesting a change in the method of accounting, the taxpayer must be able to prove to the Service that the requested
method change is a change to a method that clearly reflects
income under Section 446(b) . To avoid second-guessing and the
painful and potentially futile process of requesting a method
change for allocation of land costs, developers should initially
invest the necessary time and effort to determine an efficient
method of land cost allocation that they wish to adopt.
But what if the years are closed and an error is found? In Rev.
Rul. 70-7, 1970-1 CB 175 , the taxpayer purchased a tract of
land in 1958 for $150 and subdivided it into 15 lots with a basis
of $10 per lot. He sold eight lots to which he allocated $80 of
basis. In 1968, the taxpayer discovered that the proper cost of
the land was $75, not $150. The years in which the sales
occurred were closed under the statute of limitations. The Service determined that in connection with the sale of the remaining lots, the developer could allocate a cost of $5 per lot, what
the original cost per lot should have been. Such an allocation is
allowed even though the developer had already fully recovered
more than his actual cost of the tract. 64
Conclusion
The Service and the courts require that for tax purposes the cost
of acquiring land be equitably apportioned among the various
parcels or lots. Several methods are available for making such
allocation, some of which are specifically permitted. Others, not
specifically permitted, appear to be reasonable. In addition, the
cost of improvements, both current and future, may be allocated among these parcels or lots using the same method for
allocating the land cost. Developers should be careful in select-
Grant Thornton, LLP
Tax Planning for the Developer: Allocating Costs Among Land and Improvements
This article is an update of an excellent two-part article published more than 33 years ago in The Journal. See Sandison and
Waters, “Tax Planning for the Land Developer: Cost Allocations of Land and Improvements,” 37 JTAX 80 (August 1972),
and Sandison and Waters, “More on Tax Planning for Land
Developers: Allocations, Deductions, Reporting Income,” 37
JTAX 154 (September 1972).
9
Proper allocation is not limited to land developers. Such allocation is necessary in other areas as well, such as distributions of
property out of a partnership (see Luckey, 41 TC 1 (1963)), the
sale of a portion of a partnership interest (see Rev. Rul. 84-53,
1984-1 CB 159 ), the grant of easements (see Fasken, 71 TC 650
(1979), where the court specifically said the rules are not limited
to the subdivision of real property, and apply to vertical and
horizontal severance of realty), the receipt of condemnation
proceeds (see Soelling, 70 TC 1052 (1978)), the separation of
land and buildings for depreciation purposes (Almac’s, Inc., TC
Memo 1961-13 , PH TCM ¶61013 ), the separation of a life
estate from a fee simple interest (see Hunter, 44 TC 109 (1965)),
in connection with a ground lease separating the reversion from
the leasehold interest (see Welsh Homes, Inc., 5 AFTR 2d 1579 ,
279 F2d 391 (1960), aff’g 32 TC 239 (1959)), and the sale of
blocks of corporate securities (see Reg. 1.1012-1(c)(2) ).
12
1
2
Often a thin line separates a “dealer” from an “investor” as the
courts look at various factors, such as length of time held, number of sales, improvements made, etc. For purposes of this article, it is assumed that the developer is a dealer and is holding the
property for sale.
3
Atlantic Coast Realty Co., 11 BTA 416 (1928). See also Rev.
Rul. 86-149, 1986-2 CB 147 , and Rev. Rul. 69-536, 1969-2 CB
109 ; Homes by Ayres, 58 AFTR 2d 86-5493 , 795 F2d 832
(CA-9, 1986), aff’g TC Memo 1984-475 , PH TCM ¶84475 ;
W.C. & A.N. Miller Development Co., 81 TC 619 (1983); and
Pierce, TC Memo 1997-441 , RIA TC Memo ¶97441 .
4
Reg. 1.471-1 ; W.C. & A.N. Miller Development Co., supra
note 4; Pierce, supra note 4.
10
16
Reg. 1.263A-12(e)(2)(i) .
Section 280B .
Estate of Broadhead, 21 AFTR 2d 851 , 391 F2d 841 (CA-5,
1968); Foster, TC Memo 1966-273 , PH TCM ¶66273 ; Reg.
1.164-6 .
11
See also Rev. Rul. 72-255, 1972-1 CB 221 .
As the Supreme Court noted in Heiner v. Mellon, 20 AFTR
1263 , 304 US 271 , 82 L Ed 1337 (1938), “[p]urchasing real
estate, subdividing and selling it in parcels is, in essence, a liquidating business. The claim has been repeatedly made that no
income was realized until the investment was recouped,” but
the courts had uniformly held, and the income tax Regulations
required, that the cost of real estate be “apportioned among all
the lots, and income returned upon the sales in each year,
regardless of the number of lots remaining undisposed of at the
close of the tax year.”
13
The term “equitably apportioned” or its equivalent also is
used in Reg. 1.611-1 (depletion) and Regs. 20.2053-9 and -10
(deduction for state and foreign death taxes).
14
15
Cullinan, 5 BTA 996 (1927).
Biscayne Bay Islands Co., 23 BTA 731 (1931), citing I.T. 1843,
II-1 CB 72 I.T. 1843, II-1 CB 72.
16
Reg. 111, section 29.22(a)-11 (emphasis added), quoted in
Ewing, TC Memo 1958-115 , PH TCM ¶58115 .
17
Rev. Rul. 79-276, 1979-2 CB 200 . The point of this Ruling
was that the taxpayer could not use the cost recovery method.
18
See Cedar Park Cemetery Assn., Inc., 39 AFTR 771 , 183 F2d
553 (CA-7, 1950).
19
5
6
Reg. 1.1016-2(b) .
For a greater discussion of the costs required to be capitalized,
see Robinson, Federal Income Taxation of Real Estate, Sixth
Edition (Warren, Gorham & Lamont, 2005), ¶8.05[1].
Sleiman, 84 AFTR 2d 99-5987 , 187 F3d 1352 (CA-11, 1999),
aff’g TC Memo 1997-530 , RIA TC Memo ¶97530 .
20
21
Reg. 1.704-1(b)(2)(iv)(h) .
22
Section 1060(a)(2) .
7
8
Reg. 1.263A-2(a)(3)(ii) .
Ayling, 32 TC 704 (1959), but without citing any authority;
followed by Fairfield Plaza, Inc., 39 TC 706 (1963), and Harchester Realty Corp., TC Memo 1961-184 , PH TCM ¶61184 .
23
Grant Thornton, LLP
Tax Planning for the Developer: Allocating Costs Among Land and Improvements
Sevier Terrace Realty, TC Memo 1962-242 , PH TCM ¶62242
(emphasis added).
24
17
on the basis of square footage or acreage is not appropriate.
See also Fairfield Plaza, Inc., supra note 23, where a parcel was
sold from a tract acquired for use as a shopping center.
35
See also Soelling, supra note 2; Fieland, 73 TC 743 (1980);
Canelo, 53 TC 217 (1969); Harris, TC Memo 1968-86 , PH
TCM ¶68086 , aff’d 27 AFTR 2d 71-824 , 439 F2d 704 (CA-9,
1971).
25
26
Temp. Reg. 1.446-1T(e)(2)(ii)(a) .
Rev. Rul. 90-38, 1990-1 CB 57 ; see also Rev. Proc. 97-27,
1997-1 CB 680 , section 2.
27
28
Rev. Proc. 2002-9, 2002-1 CB 327 .
29
Rev. Proc. 97-27 , supra note 27.
Rev. Proc. 2002-9 , supra note 28; Rev. Proc. 2002-19, 2002-1
CB 696 ; Rev. Proc. 2002-28, 2002-1 CB 815 ; Rev. Proc. 200254, 2002-2 CB 432 ; and Ann. 2002-17, 2002-1 CB 561 .
30
31
Section 446(b) .
In the August 1972 article, supra note 1, the authors stated
that the developer must use the same method for both tax and
financial accounting. No authority was cited for this statement.
It appears that this statement may have been made in the interest of fairness to all parties. The authors, however, might have
been indirectly referring to Reg. 1.446-1(a)(2) , which states that
“[a] method of accounting which reflects the consistent application of generally accepted accounting principles in a particular
trade or business in accordance with accepted conditions or
practices in that trade or business will ordinarily be regarded as
clearly reflecting income, provided all items of gross income and
expense are treated consistently from year to year.” Yet this
Regulation implies that GAAP is an option, not a requirement.
GAAP does not consider real property to be inventory, consistent with the rules for tax. See Statement 1, ARB No.43, Ch. 4,
reprinted in 4 AICPA Professional Standards. Rarely are tax
and GAAP capitalization rules consistent, so differences generally exist between taxable income and GAAP income.
The Tax Court in Medlin, TC Memo 2003-224 , RIA TC
Memo ¶2003-224 , cited 2554-58 Creston Corp., 40 TC 932
(1963). There, the court said in fn. 5: “Although valuations for
real estate taxes may often be too low to be relied upon as furnishing the correct value of a particular parcel of real estate as a
whole, we have no reason to reject the use of such valuations in
determining the relative value of land and buildings.” (Emphasis
in original.) See also Almac’s, Inc., supra note 2; Cullinan, supra
note 15; and Hendrick, 35 TC 1223 (1961).
36
For example, in Stonegate of Blacksburg, Inc., TC Memo
1974-213 , PH TCM ¶74213 , the court accepted the Service’s
allocation because the taxpayer’s only evidence was that of the
company president’s uncorroborated testimony.
37
38 Estate of Walton, TC Memo 1962-63 , PH TCM ¶62063 ,
citing Union National Bank of Pittsburgh v. Driscoll, 25 AFTR
108 , 32 F Supp 661 (DC Penn., 1940).
32
Mertens, Law of Federal Income Taxation, Vol. 3A, §21.14,
quoted in Beaver Dam Coal Co., 19 AFTR 2d 338 , 370 F2d
414 (CA-6, 1966).
33
The courts in Biscayne Bay Islands Co., supra note 16, Cleveland-Sandusky Brewing Corp., 30 TC 539 (1958), and Fairfield
Plaza, Inc., supra note 23, also agreed that apportionment solely
34
39
Frazee, 98 TC 554 (1992).
The authors of the 1972 article, supra note 1, also stated that
this method should be allowed.
40
41
Ayling, supra note 23.
See Grunberger, “The §199 Deduction—Its Application to
Real Property Construction and Open Issues,” Tax Mgt. Real
Estate J., 8/3/05. See generally Conjura, Zuber, and Breaks,
“The Domestic Manufacturing Deduction: Treasury and IRS
Fill in Some Gaps,” 102 JTAX 198 (April 2005) .
42
The authors of the 1972 article, supra note 1, also agreed that
this is a reasonable method.
43
Former Internal Revenue Manual, section 4232.7, Chapters
600 and 700. This manual was last updated in 1989 and is no
longer in use. See Williford, “IRS’s Real Estate Industry Handbooks for Examining Agents,” 23 J. Real Estate Tax’n 208
(Spring 1996).
44
Training 6126-002 (Rev. 05-97), Lessons 3 and 4; reproduced
at 98 TNT 88-64 (5/1/98).
45
Grant Thornton, LLP
Tax Planning for the Developer: Allocating Costs Among Land and Improvements
Accounting Research Manager, “Accounting for Various Real
Estate Transactions,” Ch. 3, ¶¶11.1–11.7: Interpretations of
FASB Statements 66 and 67.
46
Costs in Basis: Recent Development,” 7 Real Est. Acc’g &
Tax’n 6 (Fall 1992).
57
Seidler and Carmichael, Accountant’s Handbook (1981);
Davidson and Weil, Handbook of Modern Accounting (1977);
and Morrison and Cooper, Financial Accounting (1975).
18
Rev. Proc. 92-29, 1992-1 CB 748 , section 2.01.
47
48
Id., section 5. The second and third conditions repeat the definitional requirements in section 2, noted in the text accompanying note 57, supra.
58
See Reg. 1.263A-1(f)(4) .
59
But as indicated by the Sixth Circuit in Clayton, 52 AFTR
599 , 245 F2d 238 (CA-6, 1957), aff’g TC Memo 1956-21 , PH
TCM ¶56021 , the relative sales price method may be limited to
situations where nothing occurs to alter the relative values from
the date of purchase to the date of sale.
Id., section 4.01.
49
Citing Colony, Inc., 26 TC 30 (1956), and Gersten, 28 TC 756
(1957).
50
See Leitner, Kahen, and Morris, “Allocation of Basis in Common Improvements After the Tax Court’s Norwest Decision,”
90 JTAX 154 (March 1999) .
51
See Estate of Collins, 31 TC 238 (1958); Willow Terrace
Development Co., Inc., 40 TC 689 (1963), aff’g 15 AFTR 2d
1108 , 345 F2d 933 (CA-5, 1965); Country Club Estates, Inc.,
22 TC 1283 (1954); Laguna Land & Water Co., 26 AFTR 632 ,
118 F2d 112 (CA-9, 1941); Cambria Development Co., 34 BTA
1155 (1936); and Kentucky Land, Gas & Oil Co., 2 BTA 838
(1925).
See Herzog Bldg. Corp., 44 TC 694 (1965); Memphis Memorial Park, 28 BTA 1037 (1933); Birdneck Realty Corp., 25 BTA
1084 (1932); and Mackay, 11 BTA 569 (1928), where a contractual obligation was required. See also Washington Post Co., 23
AFTR 2d 69-515 , 186 Ct Cl 528 , 405 F2d 1279 (Ct. Cl., 1969),
which held that the certainty of the liability is the most important part of the all events test, and not necessarily either the certainty of the time over which the payment will be made or the
identity of the payees. But the Service refused to follow Washington Post in Rev. Rul. 76-345, 1976-2 CB 134 . See also Cambria Development Co., supra note 52, and Haynsworth, 68 TC
703 (1977).
60
52
61
See both FASB Statements 66 and 48.
See also American Smelting & Refining Company-Consolidated, 25 AFTR 2d 70-853 , 191 Ct Cl 307 , 423 F2d 277 (Ct.
Cl., 1970).
62
Duberstein, 5 AFTR 2d 1626 , 363 US 278 , 4 L Ed 2d 1218 ,
1960-2 CB 428 (1960); Bogardus, 19 AFTR 1195 , 302 US 34 ,
82 L Ed 32 (1937); Perlmutter, 45 TC 311 (1965).
63
53
Reg. 1.461-1(a)(2)(i) ; see also Section 461(h)(4) .
See Regs. 1.446-1(c)(ii)(B) and 1.461-4(c)(1) with regard to the
definition of liability. In Molsen, 85 TC 485 (1985), the Tax
Court held that the all events test of Reg. 1.461-1(a)(2) did not
apply to purchases that are taken into account in computing
cost of goods sold. This raised a question as to whether the economic performance test of Section 461(h) applied to capital
expenditures. Nevertheless, in light of Regs. 1.446-1(c)(ii)(B)
and 1.461-4(c)(1) , it seems clear that capital expenditures are
included.
54
The conclusion of this Ruling was questioned in Haynsworth,
supra note 60.
64
© Copyright 2005 RIA. All rights reserved.
© 2006 Grant Thornton LLP, US member firm of Grant
Thornton International
For a discussion of Rev. Proc. 75-25, 1975-1 CB 720 , see
Williford and Standley, “Inclusion of Future Development
Costs in Basis: Old (and New) Rules, 7 Real Est. Acc’g & Tax’n
42 (Spring 1992).
55
56
See Williford and Standley, “Inclusion of Future Development
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