If the development of a real estate property is executed without any complications, the project will begin operations and be placed in service post-production. However, what if unexpected situations delay construction? There may not be material costs, but if a project is funded with loans, interest will continue to accrue. This article takes a closer look at the tax treatment of interest expense during prolonged real estate development.
Production Period
Generally, under Internal Revenue Code (“IRC”) Section 263A, the physical production activity defined under Section 1.263A-8(d)(1) (i.e., development or improvement to building or land) indicates the beginning of a production period for a real estate project. During the production period, direct production costs and other expenses such as real estate taxes, insurance, and interest expense may need to be capitalized if the taxpayer qualifies as a large business taxpayer that exceeds the $25 million gross receipts test under IRC Section 448(c).
Cessation Period
Even with the most sophisticated planning and scheduling, real estate developers likely agree that there are always bumps along the way, some temporary and others more permanent. The suspension of the production period occurs when the real estate’s production activity ceases for at least 120 consecutive days. The first day after the 120th day is known as the start of the Cessation Period.
As mentioned above, interest expense must be capitalized during the production period for taxpayers exceeding the $25 million gross receipts test. However, if it is determined that a property’s production is in a cessation period, the taxpayer may suspend the capitalization of interest expense and deduct interest expense immediately once the 120-day rule is satisfied.
There are additional considerations when determining whether the taxpayer’s development is in a cessation period. For example, situations considered normal or inherent in real estate development (i.e. waiting for permits and licenses or delays due to adverse weather) are not counted toward the 120 days.
If the 120-day period spans two tax years (i.e. assuming a calendar-year taxpayer, production ceases in December 2024 and the 120 consecutive days ends in March 2025), the taxpayer can suspend the capitalization of interest expense on the first day of the tax filing period (January 1 for a calendar-year taxpayer) when the 120-day period is satisfied.
Takeaways
Navigating the tax laws for various phases of real estate development and staying compliant can be complex, and the tax-saving strategies can easily be overlooked during a prolonged project. Our team of experts at Withum can assist you in analyzing a project to ensure appropriate tax savings and compliance at every step of a real estate project.
Author: Dae Kang, CPA | [email protected]
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For more information on this topic, please contact a member of Withum’s Real Estate Services Team.
