The South Florida condo market has experienced a boom in recent years, due in large part by the influx of foreign investors, many of whom are paying cash for their condos.  While cash up front is ideal and developers can use such proceeds to cover construction costs, if not properly planned and managed, developers may find themselves in an unexpected cash flow dilemma as a result of a special accounting method required under the Internal Revenue Code (the “Code”).  Where a developer enters into a contract to build and deliver a condo, and the closing will not occur within the same year such contract was executed, the developer is deemed under the Code to have executed a long-term construction contract and is required to report the income therefrom under the percentage completion method (“PCM”) of accounting.

In general, PCM is a “pay-as-you-go” reporting requirement whereby the developer reports each year (A) as gross income such portion of the total contract price that bears the same ratio that actual contract costs incurred that year bears to the total estimated contract costs and (B) the actual costs incurred that year.  By way of example, where the total contract price is $1 million and total estimated costs are $500k and the developer incurs $300k of actual contract costs in the first year, such developer reports $600k as gross income for the first year ($1 million*($300k/$500k)) and $300k of corresponding costs.  The net income from the long term contract for the first year is $300k ($600k less $300k) and, assuming the net income is taxed at the highest marginal rate of 39.6% and the developer has no other losses or deductions, taxes are due for the first year of $118,800.

In the year the contract is completed, there is a special “look back” rule that compares prior years’ estimated costs with actual costs and, in the case of an overpayment of tax by the developer, interest is due the developer and, in the case of an underpayment of tax by the developer, interest is owed by the developer.  Keeping with the forgoing example, if actual total contract costs in the year of completion are $550k, applying the look back rule to the first year, the developer should have reported $545,456 in gross income ($1 million*($300k/$550k)), $300k in offsetting costs, and $97,201 in taxes ($245,456*39.6%). As a result, the developer overpaid taxes by $21,599 in the first year and is due interest on such overpayment.

Thus, under PCM, a portion of the contract’s profits are reported each year, rather than in the year the condo is completed and delivered to the buyer (i.e. under the completed contract method), and taxes are due thereon.  The payment of taxes prior to the contract’s completion may create cash flow problems for the developer, particularly where Florida law may restrict the developer’s ability to use buyer proceeds other than for construction costs.

Where PCM is generally required, applicable Treasury regulations provide some opportunities to defer a portion of the income to later years.  Under the “10% Method”, the developer does not include in gross income any amounts from a long-term construction contract until the year in which the developer has incurred ten percent (10%) of the total estimated contract costs.  Any costs incurred prior to such year must be capitalized.  Where it is reasonably expected that eighty percent (80%) or more of the total estimated costs of a project are attributable to the construction of residential buildings (i.e. buildings containing more than four (4) dwellings), a developer may defer thirty percent (30%) of the income to the year the contract is completed and report the remaining seventy percent (70%) using PCM.  This 70/30 split is commonly referred to as the percentage-of-completion/capitalized-cost method (“PCCM”).  Using the same facts as the example above and assuming there are no changes in the contract price or estimated costs through the year of completion, where the developer uses PCCM, the developer could defer $35,640 in taxes (i.e. 30% of $118,800) until the year the contract is completed.  The look back rule would still apply in the year of completion to the portion of income reported using PCM.  Please note, however, where a developer utilizes PCCM, for alternative minimum tax purposes, such developer must use PCM to determine alternative minimum taxable income from any long-term contract.

In addition, a condo developer may avoid the requirement to use PCM by selling options to purchase condos, as opposed to entering into actual purchase and sale agreements.  Where properly timed, the buyer may then exercise the option and execute a purchase and sale agreement in the same year closing is anticipated, thereby avoiding such contract being a long-term construction contract and PCM.  Please note, however, where the price at which a buyer purchases an option is significantly greater than the price at which options are customarily granted, what is labeled an “option” may be deemed a purchase and sale agreement and thus a long-term construction contract requiring PCM.  As such, options may not be feasible where a developer anticipates using buyer funds to cover construction costs.  Further, the joint venture may be structured to provide that, in lieu of a partner receiving a carried interest, such partner receive a fee payment.  Whether a carried interest or a fee, income is ordinary because condo sales generate ordinary income.  By structuring as a fee arrangement, it should increase the total estimated costs of the long-term construction contract and decrease the pro rata portion of income required to be reported each year.

As this article briefly discusses, careful consideration should be given to revenue management.  The various accounting methods are complex and, if close attention is not paid, could result in phantom income to the developer.  Relief from PCM in its entirety may be in sight for condo developers, however. Under proposed treasury regulations, long-term construction contracts for condos would be exempt from PCM.  Until such regulations are finalized, developers must continue to use PCM subject to certain exceptions and proper planning.