Condominium Developers Tax Trap for Presold Units

Real Estate

Condominium Developers Tax Trap for Presold Units

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It is common for developers of condominium projects to sell units prior to the completion of construction.  Usually, the purchaser of the condominium secures the purchase with a deposit that is subject to forfeiture if the purchaser defaults.  The amount of the deposit depends upon market conditions.

A typical deposit may be 5% to 20% of the stated purchase price; however, the amount of the deposit can be much higher in areas with high demand.  The developer of the condominium is usually required to put the deposit into an escrow account.  The deposit may be refundable if the condo developer does not deliver the completed unit before an agreed upon deadline.
There is uncertainty in determining when the deposit is included in the taxable income of the condo developer.

Under the accrual method of accounting, the income from the presale of the condominium is deferred until the unit is completed and delivered to the purchaser.  Thus, a deposit of $100,000 on a presale contract price of $1 million will not generate income until the condo unit is completed and delivered to the purchaser.  Assuming the construction costs of the unit were $700,000, the profit of $300,000 will be reported as income in the year when the condo is delivered to the purchaser.  The condo developer will have income of $300,000 and cash available to pay taxes on this profit.

However, the accrual method of accounting is not a permissible method of accounting for long-term contracts.  Internal Revenue Code Section 460 provides that income from the construction of property that is not completed within the year the contract of sale is entered into should be accounted for under the percentage-of-completion method.  The percentage-of-completion method provides that income is recognized as the construction progresses.  Following the example above, assume that the presale contract is entered into during 2017, and that 25% of the estimated costs of construction were incurred by the end of 2017.  Under the percentage-of-completion method, 25% of the expected profit of $300,000 will be recognized as income in 2017.  Therefore, $75,000 of the $300,000 expected profit will be taxed in 2017.  The condo developer may not have any funds to pay the tax since the unit is not ready for delivery and the deposit is locked in escrow.

Forcing condominium developers to use the percentage-of-completion method is harsh and burdensome in that it results in income being recognized before cash is available to pay the taxes.  Most long-term contracts provide for progress billings to customers and unrestricted use of the receipts.  Condo developments are not structured in the same manner since purchasers make one deposit and the use of the deposit is usually restricted.

The Internal Revenue Service recognized this hardship and proposed amendments to the regulations under IRC Section 460 exempting condo units from the percentage-of-completion method.  Effectively, the proposed regulation allows the accrual method to be the correct accounting method for condo developers.  The proposed regulation was to become effective when finalized.  However, to date, the proposed regulation has not been finalized by the IRS.

Thus, the method and timing of recognizing income by condo developers continues to be uncertain.  Some condo developers continue to report their profits on the accrual method, taking the positon that the proposed regulation shows the IRS’s intent to ignore the percentage-of-completion method.  However, this is risky in that condo developers may not have substantial authority to support their conclusion.  Other condo developers have changed the language of the presale contracts to provide the purchaser with an option to buy rather than a contract for the purchase of the unit.  Again, this is risky in that the IRS may interpret the option agreement to be the same as a purchase contract.

We recommend that condominium developers perform extensive due diligence before entering into presale contracts in order to avoid potentially large premature tax liabilities.

For more information or to contact one of our Real Estate Services team member, please fill out the form below.

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Rebecca Machinga, CPA, CGMA, Practice Leader of the Real Estate Services Group
609-520-1188
[email protected]

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To ensure compliance with U.S. Treasury rules, unless expressly stated otherwise, any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

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