You may have heard the terms UNICAP or 263A, but what does it mean?
IRC Section 263A details the uniform capitalization (UNICAP) rules that require certain costs normally expensed to be capitalized as part of inventory for tax purposes.
The UNICAP rules apply to those who in the course of their trade or business:
- Produce real property for use in the business or activity;
- Produce real property for sale to customers; or
- Acquire property for resale
There are a few exceptions to this rule. If a taxpayer is allowed to use the cash method of accounting, they are not required to apply the UNICAP rules. Another exception allows resellers whose average annual gross receipts for the three previous tax years do not exceed $10 million to be exempt from this rule.
Section 263A is significant for the real estate industry, and it is specifically important for land developers and large homebuilders whose average annual gross receipts are more than $10 million and contracts exceed two years to compute. It is of interest to note that construction contractors using the percentage of completion method under Section 460, the regulations under Section 460 mirror the regulations under Section 263A.
So if you don’t meet an exception, you must look at what costs are required to be capitalized. Costs include:
- Direct Costs – these are direct material costs and labor costs that become an integral part of the property. These normally would already be included in inventory; as part of a cost accounting system.
- Indirect Costs – all costs that are not defined as direct above, but directly benefit or are incurred through the production/construction activity.
- Service Costs – a type of indirect cost that can be identified specifically with a service department. These are usually general and administrative expenses.
Indirect costs can be categorized into two groups: those that must be capitalized and those that are allowed to be expensed in the current period. Indirect costs that can be expensed in the current period include marketing, selling, advertising and distribution expenses; general and administrative expenses not related to construction or development; officers’ salaries that are not related to construction or development activities; research and experimental expenses; as well as depreciation and amortization.
A taxpayer that produces property must capitalize all costs incurred before, during and after the construction or development of the property. Many pre-construction and pre-development costs must be capitalized, such as carrying costs, real estate taxes, and costs of zoning requests related to the holding of realty for future development. Construction and development period costs are those costs that fall between the date on which construction or development begins and when it ends. Construction or development ends once the property is placed in service or is ready for sale. One item of note, interest expense only needs to be capitalized during the construction or development stage.
There are various methods that can be used to allocate the direct and indirect costs to the property produced and to determine the adjustment that must be on ending inventory and thus capitalized for tax purposes. Taxpayers can use a self-developed method or a simplified production method. Many taxpayers have adopted one of the simplified methods to ease the administrative burden associated with preparing these tax calculations.
The UNICAP rules affect a large number of taxpayers. The rules delay the expensing of capitalized costs, which ultimately results in the acceleration of taxable income. The calculations are complex and it is probably a good idea to have a tax preparer assist you with making sure you are computing them correctly and that they are in compliance with the rules of IRC Section 263A.
Article Contributed by Anca G. Stradley, CPA, MBA
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