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Focus on Home Builders: Section 199: Domestic Production Activities Deduction - New Rules and Clarifications

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The Domestic Production Activities Deduction (Section 199) became effective for the calendar year 2005 tax returns. Legislative changes as well as additional regulations issued by Treasury have provided some additional guidance on this deduction.
August 1, 2007

The Domestic Production Activities Deduction (Section 199) became effective for the calendar year 2005 tax returns. Legislative changes as well as additional regulations issued by Treasury have provided some additional guidance on this deduction. This Focus article includes a description of some of these changes for home builders.

The IRS recently issued final regulations related to Section 199, Domestic Production Activities Deduction (DPGR). The final regulations include favorable changes for the construction industry, as well as simplification and/or clarification of issues encountered by home builders.

The following information summarizes the basic calculation:

Domestic Production Gross Receipts from Construction Activities with the US
--Less Allocable Cost of Goods Sold
--Less Allocable Selling, General and Administrative Expenses
=Equals Qualified Production Activities Income (QPAI) Lesser of QPAI or Taxable Income
X Times Rate of Deduction (3% for 2005 “ 2006, 6% for 2007-2009, 9% in 2010)
=Equals Preliminary Deduction
Lesser of Preliminary Deduction or 50% of W-2 Wages
=Equals Production Activities Deduction

Provisions specific to Home Builders include:

  1. In addition to residential construction activities, the following activities may be included in DPGR in claiming the deduction:
    1. Construction of certain land improvements (e.g., roads and sidewalks)
    2. Installation of property produced by the builder
    3. Sale of some construction warranties
    4. Construction/installation of building components (e.g., heating systems, pipes, etc.)
    5. Certain management and administrative support tasks
    6. Land grading, demolition, and landscaping included in construction, if these occurred during the construction of the building (not necessarily by the same taxpayer)

  2. The final regulations incorporate rules that will decrease the compliance cost and administrative burden associ- ated with Section 199.
    1. Establishment of a de minimis rule for non-construction receipts
    2. Safe harbor rules for non-qualified land sales
    3. Limited improvements to the pass-through entity allocation rules
    4. DPGR derived from the construction of real property includes gross receipts derived from materials and supplies consumed in the construction project or that become part of the constructed real property
    5. Safe harbor for new construction ventures with respect to the industry members; clarification of the terms "engaged in the trade or business" and "on a regular and ongoing basis"

Other items changed:

  1. Change to Wage Limitation “ The deduction is limited to 50 percent of wages. Originally, this definition of wages was W-2 wages of the entity. For tax years beginning after May 17, 2006 (year 2007 for calendar year taxpay- ers), only wages related to production activities will be included as W-2 wages for the 50 percent limitation.
  2. Flow-through loss carry-forwards prior to January 1, 2005 do not reduce QPAI - If a partner or S Corporation shareholder has suspended or at-risk losses from a year prior to 2005 that are used to reduce allocable income in 2005 or after, these losses are not a reduction in qualified production activities income. This change may provide an amended return opportunity for some taxpayers who reduced their deduction on a 2005 return filed prior to this change in the regulations.
  3. Relaxation of the Item-by-item Requirement - Final regulations clarify that activities must be considered on an item-by-item basis only in order to determine the gross receipts from qualified production activities. For computing the income from these activities, an item-by-item calculation is not required.
  4. Embedded Services Exception Applies to Computer Maintenance Contracts “ Certain qualified services (warranties, delivery, installation and operating manuals) can be in

 

Under U.S. Treasury Department guidelines, we hereby inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used by you for the purpose of avoiding penalties that may be imposed on you by the Internal Revenue Service, or for the purpose of promoting, marketing or recommending to another party any transaction or matter addressed within this tax advice. Further, RubinBrown LLP imposes no limitation on any recipient of this tax advice on the disclosure of the tax treatment or tax strategies or tax structuring described herein.

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