flexiblefullpage -
Currently Reading

Custom Home Building Accounting: To Deduct or Capitalize?

Advertisement
billboard -
Business

Custom Home Building Accounting: To Deduct or Capitalize?

A recent Tax Court case highlights steps custom builders can take to get better deductions for some of their indirect costs.


By Mike Beirne, Editor July 23, 2014
Home-builder-tax-accounting-methods
columns in front of court building image for accounting for home builders story
This article first appeared in the CB July/August 2014 issue of Custom Builder.

If the tax code was more home builder friendly, then everyone in the industry could claim all their indirect costs as deductions in the same year those expenses were incurred. Consequently, the net revenue subject to tax would shrink, and builders would be able to hold on to more income.

Yet, the reality is that Section 263A of the code, also known as the uniform capitalization rules, or UNICAP, requires taxpayers producing real property to capitalize certain costs. Capitalizing an expense item means it can’t be deducted right away. So for builders, certain costs incurred when a house was built last year can’t be deducted until that house is sold whether that event happens this year or later. One exception is that home builders with averge gross receipts of less than $10 million for the three preceeding tax years are not subject to the UNICAP rules.
 
The U.S. Tax Court recently ruled against Frontier Custom Builders, Houston, which tried to substantiate deducting indirect costs, such as executive salaries, by arguing that the company was a design, marketing, and sales company. Frontier was not directly involved in construction because subcontractors actually built their products so, according to the builder’s argument, Section 263A did not apply to them. Although Frontier’s creative twist on interpreting the code is uncommon, the outcome does hold lessons for builders regarding being proactive and prepared—particularly where contemporaneous record keeping is concerned—should the Internal Revenue Service ever come calling.

Tax Court

court hammer and gavel image in accounting for home builders story
 
Frontier challenged the IRS after the agency adjusted the builder’s 2005 income tax filing to reflect $1.9 million of income under the UNICAP rules, which resulted in $653,272 in income tax owed, according to the Tax Court memo issued last September. Frontier did capitalize direct material, labor, and postproduction period carrying costs, but it claimed deductions for salaries, year-end bonuses, and other miscellaneous expenses such as the employee benefit program, general liability and vehicle insurance, mobile phone, utilities, computer maintenance, and the cost of an annual all-employee training seminar.
 
Frontier also completed its income tax filing using Generally Accepted Accounting Principles (GAAP). Those rules are not the same as UNICAP rules that require companies in the business of producing property to capitalize certain indirect costs into the cost of the property being produced and to take the deductions at a later date, such as when the property is sold.
 
“It is a complex calculation going from [GAAP], which wants you to deduct things faster from a conservative standpoint to making the complicated calculations every year to capitalize the indirect costs into your construction category,” says Mike Gracik, managing partner with Keiter, a Glen Allen, Va.-based accounting firm, which includes several Richmond builders among its clients. “The rules are complex, and I’m sure when you have complex tax rules there can be confusion about how to interpret them and how to apply them.”
 
The company contended that unlike production builders who construct houses on speculation and generate profit from price premiums and cost control, Frontier, a custom home builder, generated income from its salespeople, designers, decorators, and marketing employees. The tradesmen who actually construct the home were not Frontier employees since those activities are subcontracted out. So the Frontier employees created the product concept, rather than produced real estate, and should not have been subject to UNICAP rules.
 
Home-building-tax-accounting-methods-graphic-of-spread-sheet
 
The court disagreed, ruling that the use of subcontractors for physical home construction was not enough to exempt Frontier from section 263A. Judge Joseph Goeke wrote in his decision that the creative design of custom homes was as much a part of a development project as digging the foundation. He also upheld the IRS position that the company’s book accounting method did not comply with UNICAP rules and did not clearly reflect income. With that, the judge gave the IRS discretion to determine the accounting methods to be used, which resulted in a worse outcome for the builder and a better one for the IRS.
 
“Because the IRS made the change, Frontier had to pick up the whole $1.9 million (in income) in one year, which cost them close to $700,000 in additional tax payable in one year. If they had voluntarily changed the accounting method before the IRS came in, they could have spread that liability out over four years,” Gracik says.
 
He adds that home builders can be proactive if they are not currently following UNICAP rules for capitalizing indirect costs by simply switching their accounting method. Builders do not need permission from the IRS to do so. They simply can do a voluntary change in accounting method with the agency, which enables taxpayers to spread out any adjustment over four years. Then builders need to get with their accountants and determine which indirect costs should be capitalized and which ones can be deducted. 

Record Keeping

Home-builder-tax-accounting-methods-graphic-of-spread-sheet
 
While Frontier’s argument was unusual and the outcome perhaps was to be expected, one lesson that can be learned from this case is understanding taxpayers are allowed to do their own calculations as to which indirect costs are capitalized and which are not. Documentation is essential for this task.
 
For example, during the trial, Frontier asserted that over 90 percent of its chief executive’s time was spent on company policy and sales-related functions, which should have entitled the company to deduct his salary. But the company’s only evidence regarding the senior manager’s schedule was the executive’s own testimony regarding the number of hours he worked, which the court deemed insufficient. The builder did not maintain contemporaneous time records to show how many hours the executive or any employee spent on various activities on the company’s behalf.
 
“When we work with our clients, we encourage them to be thorough in determining how much of a particular cost is related to production activities and how much is related to nonproduction activities so they can get a better deduction,” Gracik says. “Frontier, because they thought they were exempt from those rules, had not done any of that work, and in trial (the company) was not allowed to produce that kind of evidence. They were at the mercy of the court to determine which part of the costs should be capitalized and which part should be deducted.”

Time Study

Home-builder-tax-accounting-methods-time-sheet-graphic
 
Gracik recommends builders develop their own methodology to document how much time is spent on various tasks. One of his builder clients created a spreadsheet listing the salary of every employee in the company. That company also conducted time studies to figure how much time is involved with production and nonproduction functions. Then, calculating how much of an employee’s salary to capitalize and how much to deduct is a matter of simple math and applying the time-study ratio or percentage to the dollar figure.
 
For example, the chief executive for one builder client spends most of his workdays involved with strategic planning, sales, and maintaining banking relationships. Production consumes very little of his time, so a good portion of his compensation is deducted, whereas the salaries of a vice president of operations and a project manager is capitalized because most of their duties involved home construction. Gracik has his clients create spreadsheets for all their expense categories. 
 
As to how much effort is required to compile the time data, Gracik notes the time study is not created by collecting data (punch clock, time sheets) every day or week. It’s merely the result of periodically measuring how much time employees spend working on a particular item. 
 
“We work with our clients to go through all these indirect costs and develop the evidence on a year-to-year basis as to why X amount needs to be capitalized into inventory and why a larger amount can be deducted going forward,” he says. “If you have current records and can produce that when the IRS comes calling, they pretty much leave it alone because the rules are so complex.”
 
As much as home builders and construction firms in general would prefer not to capitalize their indirect costs, there are ways for the taxpayer to get a deduction for some of those expenses.
 
“I think this case slams the door on any home builder that thought they may not have to comply with these rules because they were purely a custom home builder. From this case it should be clear, if you’re building homes, custom or spec, you are subject to these (UNICAP) rules. If you’re not complying with them now, you have the option the rest of the year to do your own studies to determine which costs should be allocated to the cost of production and which should not. You can also do a voluntary change of accounting method with the IRS and spread the adjustment over four years.” CB
 

 

Tags

Related Stories

Custom Builder

Building Relationships, Building a Business

Custom builder and Pro Builder Forty Under 40 awardee Chris Adams built his business from the ground up by first, and most importantly, building relationships

Business

Finding the Intersection of Architecture, Design, and Film

In celebration of the 15th annual Architecture & Design Film Festival, we recently sat down with its director, Kyle Bergman, to learn a little bit more about how and where architecture, design, and film come together

Business

Expanded Tax Credit for Energy Efficient Homes Will Benefit 'Eligible Contractors'

IRS guidance on the expanded 45L tax credit for energy efficient homes includes new opportunities for contractors 

Custom Builder

Take Part in Our Annual Housing Forecast

The best way to understand the residential construction industry is to speak with residential construction professionals. And with that being said, we humbly ask for your input in this year's survey

Custom Builder

Understanding Your Biggest Competitor

You may not think of yourself as a tour guide, therapist, doctor, marriage counselor, or investment advisor. But those are the skills custom builders need in today's market

Custom Builder

Women at WIRC: Jessica Cargile Talks Business Management and Work/Life Balance

Jessica Cargile owns and operates a custom building company with her husband, a dynamic that requires constant teamwork and an intentional effort to strike a healthy work/life balance 

Business

Entries Closing Soon for Best in American Living Awards

Custom builders have only one week left to submit their projects for recognition 

Custom Builder

The Power of Stories

At the 2023 Jeff Shore Sales and Marketing Summit, we sat down with author, speaker, trainer, and home building sales expert Ryan Taft to explore his thoughts on storytelling, including its role in successful sales and relationship building

Custom Builder

Building 'Living Architecture'

Master builder Jeff DuBro's novel approach to design and architecture embraces not only how clients intend to live in the home, but also how they intend to live in the surrounding community

Business

Guest Column: What I'm Seeing Out There

Industry expert and advisor Mark Richardson shares stories from the field, from what's changing to what's working 

Advertisement
boombox1 -
Advertisement
boombox2 -
Advertisement
boombox3 -
Advertisement
native1 -

More in Category

Custom Builder

Building Relationships, Building a Business

Custom builder and Pro Builder Forty Under 40 awardee Chris Adams built his business from the ground up by first, and most importantly, building relationships

Business

Finding the Intersection of Architecture, Design, and Film

In celebration of the 15th annual Architecture & Design Film Festival, we recently sat down with its director, Kyle Bergman, to learn a little bit more about how and where architecture, design, and film come together

boombox4 -
Business

Expanded Tax Credit for Energy Efficient Homes Will Benefit 'Eligible Contractors'

IRS guidance on the expanded 45L tax credit for energy efficient homes includes new opportunities for contractors 

Custom Builder

Take Part in Our Annual Housing Forecast

The best way to understand the residential construction industry is to speak with residential construction professionals. And with that being said, we humbly ask for your input in this year's survey

boombox4 -
Advertisement
native2 -
Advertisement
halfpage1 -