When you think of real estate developers, chances are you first think of the big companies that put together shopping malls, skyscrapers or big housing developments. Or, at least, that’s what I think of first.
But the fact is that you could unwittingly fall into the IRS definition of ‘real estate developer’ and that can mean some tough tax treatment.
The first problem is that you can not immediately take deductions for items you’d expect to such as property tax and interest unless the property is actually in service. And if you’re in the process of massive remodeling or changing the use of a property before you start to rent it out, then your property is not in use. At this point, the ‘not in use’ designation might simply mean you haven’t decided what you’re going to do or you haven’t found a tenant yet. But if you also are changing the property, then you additionally qualify as a real estate developer and that means one more problem.
A real estate developer is also subject to Uniform Capitalization Rules, which means he must also capitalize normal ongoing expenses and not take an immediate deduction.
Here’s an example of how wrong it can go:
Developer? Who, me?
Tom and Cecilia had a successful real estate investment and property management enterprise. They had a staff of four people who helped them with the ongoing maintenance and bookkeeping for their investments. They wanted to keep growing their business, but had reached a point where they simply couldn’t find the deals on more real estate investments. So, they decided to build new properties.
Tom had a contractor’s license and they already had the beginning of a staff to work with the sub-contractors he needed.
They bought their first parcel and began construction on a large, multi-unit apartment house. At tax time, though, they discovered that they couldn’t take a deduction for any of the payments on the land, the down payment or the out-of-pocket expenses for construction. But, they also discovered, even worse news. A large portion of the administrative and salaries for their employees were now no longer deductible.
The construction of the apartment building made Tom and Cecilia subject to Uniform Capitalization on all of their administrative expenses, even those that used to be deductible through the rest of their real estate investment business.
Avoid Real Estate Developer IRS issues by planning ahead with solid information and experienced advisors. For more information see our updated Tax Strategies for Real Estate Investors.