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Custom Homebuilder Must Capitalize Costs Incurred in Building Homes
(Parker Tax Publishing: October 20, 2013)

Frontier Custom Builders (Frontier) is a custom homebuilder that sells custom and speculative homes. It did not capitalize many of the costs it incurred in building its custom homes but rather deducted those costs. According to Frontier, custom homebuilding is different from speculative homebuilding and this difference kept its custom homebuilding activities out of the reach of the uniform capitalization (UNICAP) rules of Code Sec. 263A. The UNICAP rules of Code Sec. 263A do not apply, Frontier said, because it does not employ the tradesmen--e.g., carpenters, welders, and plumbers--who actually build the homes. All of those activities are subcontracted out. It therefore claimed that its actual employees' services, and the related costs incurred, are more reflective of a sales and marketing company that manages the creation of a custom product rather than a construction company producing streamlined goods.

Under Reg. Sec. 1.263A-1, direct costs that must be capitalized under the UNICAP rules include direct material and direct labor costs. Indirect costs that must be capitalized are all indirect costs properly allocable to property produced. Indirect costs are properly allocable to property produced when the costs directly benefit or are incurred by reason of the performance of production activities. Thus, indirect costs must be allocated between production and nonproduction activities. In addition to production costs, indirect costs include service costs. Service costs must be allocated among capitalizable, deductible, and mixed service costs.

Frontier argued that custom homebuilding is different from speculative homebuilding and that this difference keeps its activities out of the reach of Code Sec. 263A. Before Frontier sells a home, it builds it; before Frontier builds a home, it designs it. After Frontier creates the design for each custom home, it subcontracts out the physical labor to the tradesmen who actually build the home.

The Tax Court held that Frontier's use of subcontractors for the physical home construction is not enough to exempt Frontier from capitalizing costs under the UNICAP rules. The creative design of custom homes, the court stated, is ancillary to the actual physical work on the land and is as much a part of a development project as digging a foundation or completing a structure's frame. The construction of a home cannot move forward if the design step is not taken. Therefore, the court rejected Frontier's argument and found Frontier to be a producer of real property subject to Code Sec. 263A. As a result, the court held that Frontier has to capitalize all direct and certain indirect costs of production; capitalize a portion of the cost of its officer's compensation; capitalize a portion of the cost of its nonofficer employees' compensation; and capitalize a portion of its other expenses incurred.

Practice Tip: However, the parties agreed that the following expenses were fully deductible: salaries and bonuses for sales and marketing employees; state franchise tax; corporate income tax; employment tax; depreciation; legal fees for warranty claims; Web page maintenance; decorating models; bank charges; dues and subscriptions; meals; charitable contributions; and advertising.

Parker Tax Publishing Staff Writers

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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