How the Real Estate Industry Should Navigate Section 263A and UNICAP

The Uniform Capitalization (UNICAP) rules under the Internal Revenue Code (IRC) Section 263A can have a significant impact on real estate owners, developers, and investors as they require capitalization of certain costs that otherwise might be expensed, impacting tax planning and financial reporting. Navigating UNICAP can be complex, but there are strategies that can help real estate professionals comply with the regulations and avoid costly mistakes.

What Is UNICAP?

The UNICAP rules were implemented as part of the Tax Reform Act of 1986 to create a uniform set of rules for whether an expense should be capitalized to the property it relates to or whether it should be currently deductible. At the time, Congress was concerned with the variation in how taxpayers treated certain expenses. So the UNICAP rules reduced that variability while also serving as a revenue-raising provision for the federal government.

What Is IRC Section 263A?

IRC Section 263A requires businesses to capitalize direct and certain indirect costs associated with the production or acquisition of real or tangible personal property. In the context of real estate, this means capitalizing costs related to constructing, building, developing, or improving property.

At a high level, taxpayers subject to Section 263A must do the following:

1. Determine what costs are already being capitalized for book purposes.
2. Determine what costs are required to be capitalized for tax purposes.
3. Allocate the difference between the tax costs required to be capitalized (generally a higher amount) and the book costs being capitalized to the underlying property that it relates to.

Key 263A Components for Real Estate

The following type of costs are required to be capitalized:

1. Direct costs: Direct costs consist of direct materials and direct labor that become an integral part of specific property. For example, a payment to a contractor to install an HVAC system would be a direct cost of the building’s HVAC system. These costs are typically referred to as the “hard construction costs.”
2. Indirect costs: The regulations define indirect costs as “all costs other than direct material costs and direct labor costs. This would generally include what the industry refers to as “soft construction costs.” The regulations provide specific examples of both capitalizable indirect costs as well as non-capitalizable costs. Only the capitalizable costs are capitalized into the basis of the property. The non-capitalizable costs would be deductible (subject to other code provisions that could delay the timing of the deduction (i.e., IRC § 195 start-up costs)).

Capitalizable Indirect Costs	Non-Capitalizable Indirect Costs
Utilities Rent Real estate taxes Depreciation and amortization Indirect labor Indirect material Purchasing costs Employee benefits Insurance Tools and equipment Bidding costs Interest1 Certain selling, general, and administrative functions that support development (e.g., legal, HR, etc.)	Selling and distribution costs Unsuccessful biding expenses Overall management of the business, strategic planning, financial accounting, and financial planning Investor relations

Capitalizing Costs to Specific Projects

After determining what costs are required to be capitalized, the next step is allocating costs to a project and the asset classes within that project. The allocation can range from simple to very complex, depending on the number of projects and asset classes.

• Specific identification method: Traces costs to specific contracts or projects based on a reasonable relationship between the costs and the contract.
• Burden rate method: Allocates indirect costs based on a ratio, such as labor hours, using predetermined rates approximating actual indirect costs incurred.
• Standard cost method: Uses pre-established standard allowances to allocate costs. Significant variances from actual costs must be reallocated.
• Reasonable allocation methods: Taxpayers are allowed to use other reasonable allocation method subject to certain reasonableness test provided in the regulations.

Applying UNICAP to Real Estate Development

The UNICAP rules are going to require developers to capitalize costs before construction begins, during the construction period, and, in some cases, after the post-construction period.

• Pre-constructions costs: Expenses such as carrying costs, zoning requests, legal expenses, and other pre-construction costs are generally capitalized.
• Costs incurred during production: Costs during the construction period are generally capitalized with very few exceptions.
• Post-construction costs: Whether post-construction costs are required to be capitalized depends on the nature and use of the property. For example, if a manufacturer was building a new manufacturing facility, the construction period ends and the building is placed in service. Whereas a developer who is holding the property out for sale may have to capitalize ongoing carrying costs except for interest into the cost of the building since the property is effectively treated as inventory.

Exceptions: Small Businesses and Building Under Contract

In some instances, there are exceptions to the UNICAP rules. For example, small business taxpayers² may be subject to less stringent capitalization requirements which might allow them to deduct certain indirect costs (e.g., interest, real estate taxes). Additionally, if a developer is building a property under contract, they may be subject to the long-term accounting rules under § 460 rather than UNICAP. (While these rules incorporate concepts from UNICAP, they are different.)

What’s Next

Accounting for real estate costs can be challenging, and the tax rules do not make it easier. It is important to work with your advisor to appropriately apply UNICAP to avoid noncompliance and other pitfalls. For more information about Section 263A and UNICAP, contact us.

1. Special rules apply to interest expense. Typically interest paid during the production period is capitalized if it meets one of the three following criteria: (1) it relates to property with a long useful life (real property or property with a class life of 20 years or more); (2) has an estimated production period exceeding two years; or (3) an estimated production period exceeding one year and exceeding $1 million of cost.

2. Treas. Reg. 1.263A-1(j) exempts taxpayers who meet the Section 448(c) gross receipts which is generally taxpayers who have less than $29 million of average gross receipts (adjusted annually for inflation) for the prior three tax years. It should be noted, however, that common control rules may require related taxpayers to be aggregated when calculating the gross receipt amounts. Additionally, special rules apply for entities that may be considered tax shelters.