When to Expense or Capitalize Costs: Real Estate Edition

One of the biggest questions that many real estate developers encounter in the aftermath of the Tax Cuts and Jobs Act is whether or not to expense or capitalize costs that are incurred before, during and after production. The threshold for whether or not small businesses meet the exception for following capitalization guidelines was increased to $25 million, which means that indirect expenses can be deducted and only costs directly associated with production must be capitalized. For businesses with gross receipts over $25 million, the costs are more complicated. Should you expense or capitalize?

What Is the Production Period?

The production period starts the date that physical production activity takes place on the unit. Physical production activity can include things like clearing the land, engaging in landscaping, construction infrastructure like roads, demolishing the building and more.

Should You Expense or Capitalize?

Direct production costs must be capitalized and cannot be expensed. As a real estate developer, you also must capitalize real estate taxes that are paid even if no development has taken place if there is a chance that the property will be developed when the taxes are incurred.

Interest that is incurred prior to the production period can be deducted as an investment interest expense, but once the production period starts, you should capitalize it. There can be exceptions made when there is a total suspension in the production period for 120 consecutive days without counting routine delays that might occur due to weather. Many businesses encountered this dilemma on when to expense or capitalize due to the pandemic that put a pause on many projects for 120 days or more. If you paused construction for 120 consecutive days, capitalization is not required and any interest that was incurred can be retroactively deducted.

If You’re a Small Business

Small businesses have gross receipts that are less than $25 million, and they must capitalize all of the direct production costs, including at the purchase date, when the production period starts and when it is placed in service. Small businesses can deduct real estate taxes, interest expenses and insurance expenses at every step of the process.

If You’re a Large Business

Large businesses have gross receipts that are over $25 million. They must capitalize all of the direct production costs through all phases. They can capitalize real estate taxes at the purchase date and during the production period, but deduct them after it is placed in service. The interest expenses can be deducted from the purchase date to the start of the production period and after it has been placed in service, but they must be capitalized during the production period. Insurance expenses should be capitalized until it is placed in service, and then they can be deducted.

Grow Your Commercial Real Estate Business with MKS&H

MKS&H provides tax and accounting services to businesses of every size and in every industry, including commercial real estate. We can work with you to explore the many tax benefits of investment properties and assess your real estate portfolio. Contact us today for a consultation.