November 08, 2007
Author: , Jr.
There’s been a lot of buzz in recent years about Internal Revenue Code Section 199, the Domestic Production Activities Deduction. Thousands of taxpayers have realized significant benefits with the deduction, from business owners in the construction industry to those with businesses ranging from manufacturing to filmmaking.
Compared to many other Section 199 business calculations, calculations for real estate developers are not as easy to perform. However, the recent real estate development gold rush has lead many domestic developers to their best-ever profits, and Section 199 can provide some relief from the steep tax bill that follows successful investments.
Staking your claim
Developers can currently realize a 1 percent rate reduction, rising to a 3 percent tax rate reduction when fully implemented. Just as in your daily business, it will take detailed preparation to mine the value of the deduction.
Planning early in the year can help you overcome the technical nuances, the accounting/documentation requirements and the annual preparation challenges to claim the Section 199 deduction.
The following suggestions may help you stake your claim to the Section 199 deduction:
Understand the basic calculation – Taxpayers may claim a deduction equal to a percentage of the lesser of their “qualifying net income” or taxable income. Qualifying net income equals revenues earned from specific activities performed within the U.S. less the cost of goods sold and other allocable expenses.
The applicable deduction percentage for 2005 to 2006 is 3 percent and 6 percent for 2007 to 2009. For 2010 and after it peaks at 9 percent. The deduction is further limited to 50 percent of W-2 wages.
For the construction and real estate development industries, there are three primary requirements for qualifying revenue-generating activities:
- You must currently conduct construction activities on a regular, ongoing basis. Land subdivision and construction management qualify, though construction does not have to be your only or your primary line of business.
- Your construction activities must involve real property in the U.S., defined as substantial renovation or erection of real property. Infrastructure improvements qualify and include roads, water systems, sewers, sidewalks, etc. Sales of tangible personal property are specifically excluded.
- You must derive qualifying revenues from your activities, i.e., revenues earned performing construction services on real property. Sales of land by itself generally do not qualify. Other service revenues (materials delivery, debris removal, grading, demolition, painting or landscaping) may qualify if they are part of a larger project. General contractor activities like project management and oversight also qualify.
Select your guiding authority – For 2005 and 2006, taxpayers must choose between using the Internal Revenue Service’s initial guidance or applying Section 199 final regulations to calculate their deduction. This is an important decision that could impact construction material revenues, gain on land and the definition of qualifying construction activities. Generally, the final regulations are more favorable to the construction industry.
Apply de minimis exceptions and safe harbors correctly – For taxpayers whose nonqualifying receipts equal less than 5 percent of total receipts (de minimis), the IRS deems 100 percent of the receipts qualify. In addition, the final regulations allow a similar 5 percent de minimis exception based on total project revenue.
Vitally important to real estate developers is the land safe harbor. Land itself does not generate qualifying receipts. With the land safe harbor, taxpayers can calculate their land receipts by identifying land costs plus an estimated appreciation percentage.
The safe harbor percentages are 5 percent if land is held less than 60 months, 10 percent if held 60 months to 120 months and 15 percent if held 120 months to 180 months. The safe harbor eliminates the need to perform an appraisal to determine the land value.
Consider your wages – To claim the deduction, taxpayers must have W-2 wages. For example, sole proprietors with no employees (thus, no wages) will not benefit from Section 199.
Taxpayers who use professional employee organizations, employee leasing companies or multipartied, multitiered partnerships may have trouble proving or identifying their wages. However, wages could be allocated via common-law employer rules in these situations.
Also, for years beginning after May 17, 2006, Congress has implemented changes to the wage limitation calculation.
Identify your business’s differences – The real estate industry’s evolution has lead to myriad business structures and employee relationships. These business quirks could cause significant issues when you prepare your Section 199 deduction so note the following:
- If you are a taxpayer within a larger group where ownership relationships are greater than 50 percent, you may need additional consideration to determine your allocable Section 199 deduction.
- If your business is a pass-through entity, you must report specific information for your partners/shareholders to claim the deduction.
- You may claim a Section 199 deduction even if you trigger the Alternative Minimum Tax; however, the calculation’s income limitation is adjusted.
Develop your processes – Develop your processes and documentation to consistently identify, aggregate and calculate the proper data for your Section 199 calculation:
- Review your financial reports and accounting policies with your tax advisor.
- Educate accounting system users of the importance of capturing the appropriate data.
- Plan early in the year because it’s difficult to remember your activities and data after year end.
- In the event of an IRS audit, consistent calculation procedures will help you demonstrate a good-faith effort in performing an accurate calculation.
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Many real estate developers use the domestic production activities deduction to significantly lower their tax on profits and increase cash flows, but it is key to understand deduction fundamentals and to plan early.
Reprinted with permission of BKD, LLP (www.bkd.com) from Blueprint newsletter, May 2007.
Tom O. Pretti Jr. is a supervisor in the Kansas City, Missouri, office of BKD, LLP, one of the 10 largest CPA and advisory firms in the United States. He has more than six years of experience providing tax consulting services which help clients in various industries identify federal and multi-state tax savings opportunities. Contact the author at [email protected].
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