Accounting, Financial, Taxation

As real estate projects often span long time periods until their completion, it is of critical importance to evaluate at the outset of a real estate project whether — for cost allocation purposes — a project should be divided into two or more phases. For example: a real estate development company may purchase a large tract of land to be developed over several years; portions of the land will be developed and sold before the project as a whole is completed. If that real estate development project is not divided into phases, the appropriate allocation and monitoring of costs is diffi cult, and project costs relating to the earlier stages of the development may inappropriately be allocated to a later stage, thereby overstating profits in the earlier years. Certain project costs may benefit one individual unit (such as a lot, home, or condominium unit) or a group of units within one phase; other costs may benefit one or more phases of a project or more than one project, such as utilities or access roads. As such, the allocation of costs to individual units, between different phases of one project, or to different projects generally involves several cost pools and multiple steps.

When allocating project costs, one needs to consider costs already incurred, as well as costs to be incurred in current and future periods. For example: in a master - planned community, individual homes are often sold before amenities (for example, golf courses, swimming pools, or parks) have been completed. To appropriately reflect the cost of sales that relates to one individual home sold, a portion of the costs expected to be incurred in future periods for the construction of the amenities must be allocated to that home.

Selecting an appropriate cost allocation method requires judgment. As a general rule, costs should be allocated to the portions of a project that benefit from the costs. The intent is to achieve a constant gross margin on sales for the project, irrespective of the point in time sales occur. FASB Statement No. 67 outlines three different ways to allocate costs:

1. Specific identification method
2. Relative value method
3. Area methods or other value methods

Specific Identification Method

Where practicable, the costs of a real estate project are assigned to individual components of a project based on specific identification. The specific identification method is most frequently used for “the allocation of acquisition costs and direct construction costs in small projects“. For example: costs charged by a contractor to install a staircase in a new home directly relate to that home. The amount invoiced by the contractor should be included in the cost basis of that home.

Relative Value Method

If specific identification is not feasible or is impracticable, as is the case for indirect costs or common costs, costs should be allocated based on the relative value of the components, if possible. Under this method, costs are allocated based on the relative fair values of the individual components of a project, based on either “Allocation Based on Relative Fair Value before Construction“. Land costs and all other common costs incurred before construction occurs (including the costs of any amenities) are allocated to the land parcels benefited, with cost allocation based on the relative fair value before construction. For example: a developer that purchases a tract of land on which to build a master planned community, a shopping center, and an office building would allocate the cost of the land based on estimates of the relative fair value of the land parcels of (1) the master - planned community, (2) the shopping center, and (3) the office building, prior to the construction of the structures. A cost allocation based on the size of the parcels would not reflect any differences in values and is generally not considered appropriate. Unusable land and land that is donated to municipalities or other governmental agencies that will benefit the project are allocated as common costs of the project.

Allocation Based on the Relative Sales Value of the Units. Under the relative value method, construction costs for a project, such as a condominium complex, are allocated to the individual units (for example, homes, condominium units) based on the relative sales value of the units. 56 When allocating costs based on the relative value method, the sales values of the units must be comparable. This is achieved by assuming that all of the units will be completed and ready for sale at the same point in time; any expected price increases for units that will be completed in future periods are not taken into consideration.

The relative sales value method results in allocating greater costs to more valuable components of a project. In practice, the relative value method is often implemented through the application of a “gross profit method“. Under the gross profit method, a cost - of - sales percentage is calculated by dividing the sum of capitalized project costs and project costs to be incurred in the current and future periods by the estimated sales value of the unsold units. When a unit is sold, the cost - of - sales amount attributable to that sale is determined by multiplying the sales value of that unit by the cost - of - sales percentage.

Area Methods Or Other Value Methods

If the relative value method cannot be applied, as would be the case if a real estate development company has not determined the ultimate use of the land, another method for cost allocation has to be used. FASB Statement No. 67 suggests the use of the area method, such as the allocation of costs to parcels based on square footage, or “another reasonable value method”.

Under the area method, costs are allocated based on lot sizes, the square footage of a structure, or the number of units in a development. The use of the area method is appropriate only if the allocation is not materially different from an allocation that is based on relative value methods, or if the application of the relative value method is impracticable.

Cost Allocation Case Example

Developers C purchases land for $10 million, which it intends to divide into three parcels. On Parcel 1, which is along the highway, it plans to construct a shopping center. On Parcel 2, which is behind the shopping center, C plans on building a row of 40 townhouses. Parcel 3 will be developed into a master-planned community. The fair value of the land before construction has been determined to be $4 million, $1 million and $5 million for parcels 1, 2, and 3, respectively. The sales prices for the shopping center, the town houses, and the master-planned community are estimated to amount to $40 million, $12 million, and $100 million. How much land cost should be allocated to Townhouse Unit 1, which has an estimated sales price of $500,000?

The first step is to allocate the cost of the land to the individual parcels based on the relative fair value before construction; accordingly, an amount of $1 million is allocated to Parcel 2. The land value allocated to the parcel on which townhouses are to be constructed then becomes part of the common cost pool for the townhouse, which is allocated to each townhouse based on its relative sales value. As such, Townhouse Unit 1 will be allocated land costs of $41,667. That amount is calculated as follows:

The sales value of Townhouse Unit 1 divided by the sales value of all Townhouses, multiplied by the cost of land allocated to the townhouse development: $0.5 million/$12 million multiplied by $1 million.

The allocation of costs needs to be reviewed every reporting period to ensure that changes in circumstances, such as a change in estimate of project costs or sales prices or in the design of the project, are taken into consideration. Cost reallocations within or between phases of a project are not uncommon, as the design of a project may evolve.

Project costs are defined as “costs clearly associated with the acquisition, development, and construction of a real estate project”. In certain real estate projects, land is developed and structures are being built or refurbished. In addition to the costs of acquiring land, development and construction costs are incurred to complete the project. Other real estate projects involve property acquisition only, such as the acquisition of shopping centers that are already in operation.

Paragraph 7 of Statement 67 states the general concept for the accounting for project costs:

Project costs clearly associated with the acquisition, development, and construction of a real estate project shall be capitalized as a cost of that project. While this concept may appear straightforward, determining which costs are clearly associated with a real estate project can require significant judgment.

Direct Costs

Direct project costs are incremental costs that are directly related to the acquisition, development, and construction of the property. They may include the same types of costs as pre-acquisition costs, because certain activities can be performed before or after the acquisition. In addition to the types of costs, project costs typically include:

1. Purchase price
2. Commissions due to third parties
3. Brokerage fees due to third parties
4. Fees for title guarantee and title searches
5. Recording fees
6. Property taxes incurred during construction
7. Insurance costs incurred during construction
8. Environmental remediation costs
9. Demolition costs
10. Construction costs (materials, labor)
11. Costs of amenities
12. Donated land

All costs incurred need to be carefully evaluated to determine whether they qualify for capitalization. For example, the costs of real estate donated to governmental agencies that benefit a certain project are part of that project’s costs.

However, if donated land does not benefit (and was not made in conjunction with) a real estate project, the costs should be expensed, rather than capitalized. Similarly, demolition costs incurred within a reasonable period after the acquisition of property are generally capitalized when they are incurred, if demolition is probable at the time of acquisition. Industry practice is diverse with respect to the capitalization of demolition costs that are not incurred within a reasonable period after acquisition. The proposed SOP, if it had been issued in final form as proposed, would have required that demolition costs not incurred within a reasonable period of time after acquisition be expensed. Questions also arise with respect to the capitalization of environmental remediation costs. While environmental remediation costs incurred within a reasonable period of time after the acquisition of property are generally capitalized as part of the project costs, determining whether environmental remediation costs incurred at a later point in time are capitalizable
is more complex and involves significant judgment.

Indirect Costs

Indirect project costs are capitalized to the extent they clearly relate to the acquisition, development, or construction of a real estate project. The following are examples of indirect internal project costs:

1. Costs of planning department
2. Costs of construction administration (for example, the costs associated with a field office at a project site)
3. Internal costs incurred for cost accounting or project design
4. Depreciation of machinery and equipment used directly in construction
5. Payroll costs and employee benefi ts for employees working on the project

For internally incurred indirect costs to be capitalizable, a cost accounting system needs to be in place and adequate documentation needs to be maintained to support cost capitalization. For example: time may be recorded by the in – house designers to determine the percentage of their salaries to be allocated to a certain project. Indirect costs for which sufficient support cannot be provided, or that do not clearly relate to a project under development or construction, including general and administrative expenses, are expensed as incurred.

Statement 67 does not provide any further guidance on how to determine what costs are clearly associated with the acquisition, development, and construction of a real estate project. As a result, considerable diversity in practice exists with respect to the types of indirect project costs that are capitalized.

The proposed SOP, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment , limits the capitalization of indirect costs to:

1. Costs that are directly identifiable with the specific property
2. Costs incurred for property taxes and insurance for the portion of the property under construction
3. Demolition costs incurred in conjunction with the acquisition of PP & E, if demolition is probable at the time of acquisition and is expected to occur within a reasonable period after acquisition.

The proposed SOP, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment , provides that the capitalization of directly identifable indirect project costs should be limited to:

1. Incremental direct costs of acquiring, constructing, or installing the property
2. Payroll and payroll benefit – related costs of employees who devote time to the project
3. Depreciation of machinery and equipment used in construction or installation
4. The cost of inventory used in construction or installation

The proposed SOP does not provide for the capitalization of other indirect costs, such as occupancy costs (including rent, depreciation, and other costs associated with facilities); these costs should be charged to expense as incurred.

While the proposed SOP may prove helpful in interpreting Statement, one has to keep in mind that the FASB has not cleared that proposed SOP, and therefore, it is low - level GAAP.

General and Administrative Expenses

FASB Statement No. 67 provides that:

indirect costs that do not clearly relate to projects under development or construction, including general and administrative expenses . . . be charged to expense as incurred ” 30 without providing further guidance as to which expenses should be considered general and administrative expenses. The proposed SOP, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment , is more specific: “ All costs (including payroll and payroll benefit related costs) of executive management, corporate accounting, acquisitions, office management and administration, marketing, human resources, and similar costs and functions should be charged to expense as incurred.

Property Taxes and Insurance

Property taxes, insurance, and interest are commonly referred to as holding costs. Taxes and insurance are capitalized as part of the property ’ s cost during the period in which activities necessary to get the property ready for its intended use are in progress. The capitalization period for property taxes and insurance (beginning, end, and suspension) coincides with the capitalization period for interest set forth in FASB Statement No. 34, Capitalization of Interest Cost. After the real estate property is ready for its intended use, property taxes and insurance are charged to expense as incurred. Special considerations are necessary when development activities occur only on a portion of a real estate property. For example: a company may own a 50 - acre parcel of land and is constructing a building on 5 of these 50 acres. The capitalization of property taxes and insurance would only be appropriate for interest and taxes relating to the fi ve acres under construction.

Insurance and taxes are capitalized during the construction period irrespective of whether the real estate is newly acquired or whether it has been used subsequent to its acquisition, with construction activities starting at a later point in time. For example: a hotel building may be redeveloped (refurbished) after it has been operating for many years. The proposed SOP, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment, uses the “ voidable cost concept” to determine whether property taxes and insurance should be capitalized. If the property has been used in the past as an operating asset, but is removed from operations for purposes of construction, property taxes and insurance are avoidable costs of construction, even though they are not incremental to the entity, since the entity could avoid the property taxes and insurance by choosing to dispose of the property.

However, for properties under construction that remain in operation while construction takes place, the proposed SOP suggests that costs incurred for property taxes and insurance should be capitalized only if they are incremental and directly attributable to the construction activities.

Interest

Undertaking real estate projects requires significant capital, and financing cost is a major cost factor. If real estate is acquired that is not ready for its intended use, interest expense incurred during the development and construction period is part of a project ’ s costs that is capitalized. FASB believes that through interest capitalization, a measure of acquisition cost is obtained that reflects the company ’ s investment in the real estate asset. Accordingly, interest capitalization is not discontinued when a real estate project is impaired; any write - down is increased by interest expected to be capitalized in future accounting periods.

There may be a period of time in which a company generates interest income from the investment of unused funds on project fi nancing obtained. Generally, such interest income is recognized as income when earned. It is not offset against interest cost when determining the amount of interest cost to be capitalized, except in the case of certain tax - exempt borrowings.

The determination of the amount of interest to be capitalized in a real estate project is a four - step process:

Step 1. Determine Whether The Real Estate Project Qualifies For Interest Capitalization

The following assets qualify for interest capitalization:

1. Assets that are constructed or otherwise produced for a company ’s own use
2. Assets intended for sale or lease that are constructed or otherwise produced as discrete projects, such as real estate developments.

Additionally, investments in equity method investees may be qualifying assets.

FASB Statement No. 34, Capitalization of Interest Cost, precludes interest capitalization for certain types of assets, including (1) assets that are in use or ready for their intended use, and (2) assets that, although not in use, are not undergoing activities to get them ready for their use.

Land that is not undergoing activities necessary to get it ready for its intended use is not an asset qualifying for interest capitalization. Once activities are undertaken for the purpose of developing land for a particular use, the acquisition and development expenditures qualify for interest capitalization while those activities are in progress. If a structure is built on the land, such as a plant or an office building, interest capitalized on the land expenditures is part of the cost of the structure. If a tract of land is developed and subdivided to be sold as developed lots, interest capitalized on the land expenditures becomes part of the cost of the land.

Step 2. Determine The Types Of Expenditures That Qualify For Interest Capitalization

After it has been determined that a project qualifi es for interest capitalization, the expenditures incurred for that project have to be evaluated to determine whether they qualify for interest capitalization. As a general rule, expenditures that do not require the transfer of cash or other assets or the incurrence of liabilities on which interest is accrued do not qualify for interest capitalization. As such, capitalized amounts financed through trade payables, retainages, or progress payment collections from customers may lead to differences between capitalized project costs and the amount of expenditures that qualify for interest capitalization. Paragraph of FASB Statement No. 34 provides, however, that capitalized expenditures for an asset may be used as a reasonable approximation of expenditures on which interest is capitalized, unless the difference is material.

Step 3. Determine The Capitalization Period

Interest is capitalized when the following three conditions are present: Expenditures for the asset (that qualify for interest capitalization) have been made.

Activities that are necessary to get the asset ready for its intended use are in progress.

Interest cost is being incurred.

The term “activities that are necessary to get the asset ready for its intended use” is interpreted broadly in practice. Such activities include administrative and technical activities before ground is broken, such as the development of plans or the process of obtaining permits from governmental authorities. If a company suspends substantially all activities related to the development of the property, the company has to evaluate the reason and duration of the suspension and determine whether interest capitalization during such period of suspension is appropriate.

An interruption that is brief or inherent in the asset development process, such as labor strikes or weather conditions, would not lead to a cessation of interest capitalization, whereas a company - induced suspension in construction activities due to a decline in the real estate market would preclude interest capitalization.

The capitalization period ends when the asset is substantially complete and ready for its intended use. By requiring that the capitalization period end when the asset is “substantially complete”, the FASB intended to prohibit the continuation of interest capitalization in situations in which the fi nal completion of assets is intentionally delayed. For example: a developer may choose to defer installing fixtures and fittings until condominium units are being sold to give buyers a choice of styles and colors.

Paragraph 22 of FASB Statement No. 67 allows for a maximum period of one year after cessation of major construction activities, over which a developer may assert that the project is not substantially completed, by requiring that:

….a real estate project shall be considered substantially completed and held available for occupancy upon completion of tenant improvements by the developer but no later than one year from cessation of major construction activity . . .

Real estate projects may need to be divided into separate assets or parts for purposes of determining whether they are ready for their intended use. For example: a condominium building is comprised of individual condominiums, which can be used independently from each other. 47 Each such condominium constitutes a separate asset, and interest ceases to be capitalized on condominiums that have been completed and are ready for use. Other real estate assets must be completed in their entirety before any part of the asset can be used, such as the construction of a manufacturing facility.

Judgment must be exercised when determining whether a real estate project should be divided into separate parts for purposes of interest capitalization.

Step 4. Determine The Amount Of Interest Cost To Be Capitalized

The amount of interest cost to be capitalized is intended to be that portion of the interest cost incurred during the asset’s acquisition and construction period that theoretically could have been avoided if expenditures for the asset had not been made.

The total amount of interest cost that may be capitalized in an accounting period is limited to the total amount of interest cost incurred by the company in that period. For purposes of FASB Statement No. 34, interest cost incurred by a company includes:

1. Interest recognized on obligations with explicitly stated interest rates (including the amortization of discount or premium and debt issue costs).
2. Interest imputed on certain types of payables, in accordance with Accounting Principles Board (APB) Opinion No. 21, Interest on Receivables and Payables.
3. Interest on capital leases determined in accordance with FASB Statement No. 13, Accounting for Leases.

The amount of interest cost to be capitalized in an accounting period is determined by applying an interest rate to the average amount of accumulated expenditures for the asset during the period. In determining what interest rate to use, the objective is to determine a reasonable measure of the cost of financing the acquisition and development of the asset. The interest rate or interest rates used should be based on the rates applicable to borrowings outstanding during the period. If a company has obtained a specifi c loan for a qualifying asset, the company may use the rate on that borrowing as the capitalization rate for the expenditures for the asset. If the average accumulated expenditures for the asset exceed the amounts of that loan, the capitalization rate applied to any excess is a weighted average of the rates applicable to other borrowings of the company.

Paragraph 14 of Statement 34 provides with respect to the weighted average interest rate to be used:

In identifying the borrowings to be included in the weighted average rate, the objective is a reasonable measure of the cost of financing the acquisition of the asset in terms of the interest cost incurred that otherwise could have been avoided. Accordingly, judgment will be required to make a selection of borrowings that best accomplishes that objective in the circumstances.

 

Further worth reading: Cost Allocation

Pre-acquisition costs are costs related to a real estate property that are incurred for the express purpose of, BUT PRIOR TO, obtaining that property. They may include a variety of costs, such as:

1. Payments to obtain an option
2. Legal fees
3. Architectural fees
4. Other professional fees
5. Costs of environmental studies
6. Costs of feasibility studies
7. Costs of appraisals
8. Costs of surveys
9. Planning and design costs
10. Costs for zoning and traffic studies

Principles for the Capitalization of Pre-acquisition Costs

1. Payments for options to acquire real property are capitalized.
2. Pre-acquisition costs other than the cost of options can only be capitalized if the acquisition of the property (or an option to acquire the property) is probable, and if the costs meet the following two criteria:
3. The costs must be directly identifiable with the property.
4. The costs would be capitalized if the property were already acquired.

FASB Statement No. 67 has established a high threshold for the capitalization of pre-acquisition costs with the requirement that the acquisition of real property be probable:

1.  If the purchaser is not actively seeking to acquire the real estate property or does not have the ability to fi nance or obtain financing for the property, or if there is an indication that the real estate property the purchaser seeks to acquire will not be available for sale, the project is not considered probable.
2. Any costs (other than costs relating to an option to acquire real estate) incurred before a project is considered probable have to be expensed as incurred.
3. If the project becomes probable at a later point in time, costs incurred prior to the project becoming probable cannot subsequently be capitalized.

Example Of Pre-acquisition Costs

Company B plans to build five storage centers in various cities throughout the United States. Ten suitable land parcels have been identified. The land parcels upon which B is considering building the storage centers are for sale, and B has the ability to obtain financing. The final decision as to which locations to use for the storage centers will be made after certain feasibility studies have been completed. To date, B has paid advisors $1 million for feasibility studies. Can B capitalize the costs incurred for these feasibility studies?

The answer is: No.

Reason:  Since B has not identified the specific locations for the storage centers, the costs incurred should be expensed.

Pre-acquisition costs that meet the requirements for capitalization outlined above are capitalized. Once the real estate property is acquired, any capitalized pre-acquisition costs are included in project costs. If, on the other hand, a company determines that the acquisition of the property is no longer probable, capitalized pre-acquisition costs are charged to expense to the extent they are not recoverable through the sale of plans, options, etc.

The proposed SOP, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment, states with respect to pre-acquisition costs when it becomes probable that the property will not be acquired:

If it becomes no longer probable that specific PP & E [property, plant, and equipment] will be acquired or constructed, previously capitalized pre-acquisition stage costs related to the specific PP & E should be reduced to the lower of cost or fair value. A rebuttable presumption exists that the fair value of the asset consisting of those pre-acquisition stage costs (excluding option costs) is zero (that is, the costs of the asset would be charged to expense), unless management, having the authority to approve the action, has committed to a plan to either (a) sell the asset and the proceeds can be reasonably estimated or (b) redeploy the asset in other specific PP & E of the entity and the redeployed asset meets the criteria for capitalization under the project stage framework in this SOP. If an entity subsequently acquires or constructs PP & E previously considered no longer probable to acquire or construct, pre-acquisition stage costs charged to expense under this paragraph should not be reversed.

AcSEC establishes a rebuttable presumption that the fair value of any capitalized pre-acquisition costs is zero once a project is abandoned, because the majority of the costs incurred in this stage would be “ soft ” costs that would generate only limited value for other projects.

Capitalization of Internal Pre-acquisition Costs

Activities in the pre-acquisition stage may be carried out by a company ’ s in - house departments, which raises the question of (1) whether and (2) to what extent such internal pre-acquisition costs should be capitalized.

Emerging Issues Task Force (EITF) Issue No. 97 - 11, Accounting for Costs Relating to Real Estate Property Acquisitions, provides that internal pre-acquisition costs 10 are only capitalizable if the property is expected to be non-operating at the date of acquisition. They are not capitalizable if the property is expected to be operating at the date of acquisition, such as internal pre-acquisition costs relating to the purchase of an existing shopping mall.

A prerequisite for the capitalization of internal pre-acquisition costs is that they be directly identifiable with the specific property.  While “directly identifiable” is not further defined in Statement 67, the term has been interpreted narrowly in practice.

One may look to the proposed SOP, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment, for implementation guidance:

. . . directly identifiable costs include only:

1. Incremental direct costs of PP & E pre-acquisition activities incurred for the specific PP & E.
2. Certain costs directly related to pre-acquisition activities performed by the entity (or by parties not independent of the entity) for the specific PP & E. Those costs include only payroll and payroll benefit – related costs (for example, costs of health insurance) of employees who devote time to a PP & E pre-acquisition stage activity, to the extent of time the employees spent directly on that activity and in proportion to the total hours employed.

 

Further, that proposed SOP states that costs of facilities, such as rent and depreciation, as well as general and administrative costs, should be expensed as incurred, as should all costs of executive management, corporate accounting, acquisitions, office management and administration, marketing, human resources, and similar costs or functions. 15

While that proposed SOP has never been issued in final form, the guidance provided by that proposed SOP nevertheless proves helpful when interpreting the provisions in Statement.

Payments to obtain an option . . . to acquire PP & E. Notwithstanding the foregoing, an option to acquire property, plant, and equipment that meets the definition of a derivative instrument within the scope of FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, is accounted for following the guidance in Statement 133.

For worth reading about accounting real estate topic: Project Costs