David McKelvey is a certified public accountant and tax advisor to developers and construction firms as a principal at Friedman LLP in New York. His e-mail address is dmckelvey@friedmanllp.com.

Tax Pitfalls for Developers and Builders

Seemingly routine tax decisions in the development world can have serious long-term financial consequences.

by David P. McKelvey

With tax filing deadlines fast approaching, it’s a good time to point out some of the potential tax pitfalls facing builders and developers. It is critical to sidestep overpayment and underpayment mistakes that take profits from your business or invite Internal Revenue Service audit exposure, interest, and penalties. Plan with your tax advisor to avoid the following situations:

Losing REP status: Most taxpayers that are contractors, developers, or both meet the IRS definition of a “Real Estate Professional,” which generally is a taxpayer whose work involving real property development, construction, rental, or management entails: spending more than half of his or her total annual work time, and at least 750 hours overall, on such activity; and “materially participating” in that activity. Qualifying for REP classification can be lucrative because it allows an unlimited deduction of losses from rental real estate activities, including any loss from operating a residential or commercial rental property, where costs can include mortgage interest, depreciation, repairs, maintenance, and management.
That unlimited deduction of rental losses for REP taxpayers can be used to offset many other kinds of income, such as development profits, wages, interest, and dividends. Taxpayers that do not qualify as REPs, on the other hand, generally must cap their losses from rental activities in the current tax year at the amount of income generated from other, profitable rental real estate activities – exposing themselves to tax liability from nonrental income sources.
But even if you qualify as an REP, it’s easy to lose the main benefit it allows – the unlimited deduction of losses – if you fail to take a simple step. While the material participation rule requires an REP to spend more than 500 hours a year working on a rental property, it allows the taxpayer to elect to treat multiple rental real estate properties as a single activity.
Failing to make that election can be a costly mistake. Take Bob the builder as an example, who has been in business for decades and amassed 35 multi-unit rental properties, each owned in a separate entity. He was audited, and the IRS pressed for three years of material participation documentation on each property to justify the deduction of his rental losses.
While he claimed to meet the REP time requirements, he failed to make the election. Suddenly, he faced the impossible task of showing independent material participation in each of the 35 rental properties – the equivalent of seven years of time in a single tax year. Bob was naturally unable to document enough hours (or meet any of the other material participation tests) and was assessed hundreds of thousands of dollars in taxes for which he otherwise would have not been liable.

Capital gains errors: Vera, a real estate investor and developer, bought land for $2 million, saw it appreciate to $5 million over several years, and decided to develop it and sell the units. But Vera failed to protect herself by creating a new business entity that would develop the property separately from the investment entity that owned the land. As a result, when she earned an additional $1 million in profit from development, she transformed her $3 million of capital gain income from the appreciation of the property into ordinary income - and paid an extra $600,000 in taxes. Had she made the right tax changes, she could have maintained her capital gain income on the appreciated value and only paid ordinary income tax on the $1 million of development income.

Charitable land woes: Developers working in a municipality will often donate a parcel of land to the public entity, with the fair market value of the property serving as the value of a charitable contribution. However, the IRS will assess whether the donor is getting any direct or indirect benefit from the municipality as a result of the donation, including zoning approval or road construction. The IRS does not hesitate to challenge charitable tax treatment if its examiners believe you are receiving a tangible business benefit in return. These donations should be made carefully and with recognition that intentions can be scrutinized.