SERVICE RULES THAT REAL ESTATE DEVELOPER MAY NOT USE INVENTORY METHOD OF ACCOUNTING

Rev. Rul. 86-149

ISSUE

Whether a taxpayer engaged in the business of developing real estate may use the last-in, first-out (LIFO) inventory identification method in accounting for the costs of its completed homes and homes under construction, exclusive of land costs?

FACTS

The taxpayer is a real estate developer that keeps its books and records and files its federal income tax returns on an accrual method of accounting. Its principal business activity is developing real estate upon which it constructs residential homes.

The taxpayer uses an accumulated "job cost" method to account for its construction and development costs. Under this method, each home is treated as a separate costing unit to which all direct identifiable costs are charged and all overhead costs, including the variable overhead as well as the construction and architectural costs, are allocated. All costs that have been accumulated for a particular home under the job cost method are charged to cost of sales at the time of settlement with the purchaser of the home.

With its federal income tax return filed for the year ended 1984, the taxpayer filed a timely Form 970, Application to Use LIFO Inventory Method, for its "inventory" of completed new homes and jobs in progress. The cost of its building lots, including the various development costs of improving the lots such as streets, curbs and gutters, were not included in the application to use the LIFO method.

LAW AND ANALYSIS

Section 263(a)(1) of the Internal Revenue Code and section 1.263(a)-1(1) of the Income Tax Regulations provides that no deductions shall be allowed for any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate.

Section 1.263(a)-2 of the regulations sets forth examples of capital expenditures, including the cost of acquisition, construction, or erection of buildings, machinery and equipment, furniture and fixtures, and similar property having a useful life substantially beyond the tax year.

Section 446(a) of the Code states that general rule that taxable income shall be computed by a taxpayer under the method of accounting it regularly uses in keeping its books. Section 446(b), however, provides that where a taxpayer's accounting method does not clearly reflect income, the computation of taxable income shall be made under such method as, in the Secretary's opinion, does clearly reflect income.

Section 471 of the Code provides that whenever in the opinion of the Secretary the use of inventories is necessary in order clearly to determine the income of any taxpayer, inventories shall be taken by such taxpayer on such basis as the Secretary may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting income.

Section 472(a) of the Code allows a taxpayer to use the LIFO method in inventorying goods specified in an application to use such method filed at such time and in such manner as the Secretary may prescribe.

Section 1.471-1 of the regulations provides that inventories at the beginning and end of each tax year are necessary in every case in which the production, purchase or sale of merchandise is an income- producing factor.

Section 1.472-1(a) of the regulations provides that any taxpayer permitted or required to take inventories pursuant to the provisions of section 471 of the Code may elect with respect to those goods specified in its application and properly subject to inventory to compute its opening and closing inventories in accordance with the method provided by section 472.

Whether a real estate developer may use the LIFO method to account for the costs of its completed homes and jobs in progress is dependent upon whether the taxpayer is required or permitted to maintain inventories with respect to these costs. Historically, taxpayers engaged in the real estate business have not been permitted to inventory real estate held for sale to customers. Atlantic Coast Realty Co. v. Commissioner, 11 B.T.A. 416 (1928); Rev. Rul. 69-536, 1969-2 C.B. 109. In Atlantic Coast Realty Co., the United States Board of Tax Appeals concluded that, based on the purpose and legislative intent of the inventory provisions, the use of inventories is inappropriate for a taxpayer engaged in buying and selling lands. As stated by the Board of Tax Appeals on page 419:

The use of inventories must be reasonably necessary to the determination of income. The basis of their use must be prescribed by the Commissioner, not arbitrarily, but in conformity to the best accounting practice in the trade or business and as most clearly reflecting income. The language indicates no intention to recognize in any trade a new method of determining income or a new limitation upon income, but only a recognition of the use of inventories in such trades or businesses, like "manufacturing and merchandise concerns" as had been found to require such accounting practice.

Unlike a manufacturing or merchandise concern, the use of inventories for the valuation of either unimproved land or developed real estate is unnecessary for the determination of income and generally impractical s a method to value real estate. See Atlantic Coast Realty Co. Real estate is unique and is particularly subject to specific accounting of costs including the tracing of costs to individual parcels and the separate computations of gains or losses on sales. See for example, Rev. Rul. 66-247, 1966-2 C.B. 198, which states that capitalized costs incurred in the construction of a house for speculative sale should be applied against the amount realized upon the sale of the house for purposes of determining gain or loss.

Instead of being a more convenient method of accounting, as it is with large stocks and merchandise, an inventory method for real estate could be so cumbersome and uncertain as to be generally impractical. Atlantic Coast Realty Co. For this reason, neither the land nor the materials and supplies used to construct the houses on the lots are considered merchandise or goods within the meaning of section 471 of the Code and its regulations. See Homes by Ayres v. Commissioner, 795 F.2d 832 (9th Cir. 1986), aff'g T.C.M. 1984-475; W. C. & A. N. Miller Development Co. v. Commissioner, 81 T.C. 619 (1983); see also Francisco Sugar Co. v. Commissioner, 47 F.2d 555 (2nd Cir. 1931), aff'g in part 14 B.T.A. 1062 (1929). Instead, the property and its improvements constitute real estate held for sale by the taxpayer. See section 263(a)(1).

In the instant situation, therefore, the taxpayer is neither permitted nor required to maintain inventories. Its job order cost method for accumulating the costs of its completed but unsold homes and construction in progress is not an inventory method but a capitalization method even though it may approximate the results of a specific identification inventory method. W. C. & A. N. Miller Development Co. As stated by the United States Tax Court in W. C. & A. N. Miller Development Co. on pages 632 and 633:

There is a fundamental difference between capitalization and an inventory method. Under capitalization, gain will be determined pursuant to section 1001 on each individual home when it is sold, and such gain is to be determined based generally on the taxpayer's actual cost for that particular home. Since the specific identification method of inventory valuation is only one of several permissible inventory methods, there is not necessarily the requirement under this method that actual cost be used in arriving at cost of goods sold.

Thus, the Tax Court held that a seller of homes cannot maintain inventories.

A taxpayer engaged in the real estate business capitalizes its costs in accordance with section 263 of the Code. Under section 263(a)(1), costs incurred in the construction of homes and other permanent improvements to real property are not currently deductible. Instead the cost of unsold homes and construction in progress is capital expenditure that becomes part of the cost of the real estate, which, in turn, is recovered either through a depreciation allowance if the property is used in a trade or business, or as an offset against the price received in the subsequent sale or disposition of such property.

By utilizing the LIFO method of inventory accounting for its completed but unsold houses and costs of construction in progress, the taxpayer may be, in effect, deducting a portion of its construction costs before it has actually disposed of the real property. For example, as construction costs increase, the LIFO method will produce a cost of goods sold deduction in excess of the cost specifically attributable to the particular real property actually disposed of during the year and in effect the taxpayer will be currently deducting the cost of mproving other real property prior to its sale..Thus, as a consequence of utilizing he LIFO inventory method in ccnjunction with its job order cost method, the taxpayer is selectively combining attributes of both an inventory method and a capitalization method with a resulting distortion of income within the meaning of section 446(b) of the Code.

HOLDING

A taxpayer engaged in the business of developing real estate may not use the LIFO inventory identification method to account for its completed homes and homes under construction, exclusive of land costs.

Any change from the taxpayer's present method of accounting for its construction costs to the method described in this revenue ruling is a change in method of accounting to which section 446 and 481 of the Code and the regulations thereunder apply.

This ruling is identified as a designated ruling pursuant to section 5.12(2) of Rev. Proc. 84-74, 1984-2 C.B. 736.

EFFECT ON OTHER DOCUMENTS

Rev. Rul. 69-536, 1962-2 C.B. 109 amplified.