For tax years beginning after 2004, taxpayers can claim a deduction to offset income from domestic manufacturing and other domestic production activities. For 2005, the Code Sec. 199 production deduction equals 3% of the lesser of: the taxpayer's qualified production activities income or total taxable income (adjusted gross income, in the case of a sole proprietor) for the year. The deduction is limited to 50% of the W-2 wages paid by the taxpayer. Qualified production activities income is domestic production gross receipts-which includes construction activities performed in the U.S.-with certain reductions.
Recently released proposed regulations under Code Sec. 199 provide that a taxpayer that sells developed land and who is otherwise entitled to claim the Code Sec. 199 deduction for construction activities will have domestic production gross receipts to the extent the receipts are attributable to real property such as infrastructure (roads, water and power lines, sewers, sidewalks, etc.), but not to the extent attributable to the land and any entitlements attributable to the land. The proposed regs provide a safe harbor method for allocating gross receipts between the proceeds from the sale, exchange, or other disposition of real property constructed by the taxpayer (which qualifies for the Code Sec. 199 deduction) and the gross receipts attributable to the sale, exchange, or other disposition of land (which doesn't qualify for the deduction).
Under the safe harbor, a taxpayer may calculate the gross receipts attributable to the sale of land by adding a "deemed profit markup percentage" to the costs of the land and any other costs capitalized to the land (collectively termed land costs) including zoning, planning, entitlement costs, and other costs capitalized to the land. The deemed markup percentage is based on the number of years that elapse between the date the taxpayer acquires the land, including the date the taxpayer enters into the first option to acquire all or a part of the land, and ends on the date the taxpayer sells each item of real property on the land. The deemed markup profit percentage is 5% for up to 5 years; 10% for years 6 through 10; and 15% for years 11 through 15. Land held by a taxpayer for 16 or more years is not eligible for this safe harbor.
Illustration: X is in the business of constructing housing. On June 1, 2005, X pays $6,000,000 for 100 acres of land that X will develop as a new housing development. The development will consist of 100 houses to be built on half-acre lots over 5 years; 50 acres will be used for lots, and the other 50 acres will be used for common grounds. Accordingly, the cost for each half-acre lot is $30,000 ($6,000,000 ÷ 100 houses ÷ 2 houses per acre).
On Jan. 31, 2010, the first house is sold for $300,000. The construction cost for each house is $170,000 and the average cost per lot for common improvements is $55,000, of which $25,000 represents infrastructure and $30,000 represents land costs.
Qualified production activities income on the sale of the home is calculated as follows:
- Construction costs for house $ 170,000
- Construction costs for infrastructure $ 25,000
- Costs allocated to domestic production gross receipts on house (a + b) $ 195,000
- Total gross receipts $ 300,000
- Less receipts from land based on cost of land ($30,000 lot plus $30,000 common area) $ 60,000
- Less 5% Additional Markup on Land (e x 5%) $ 3,000
- Domestic production gross receipts (d-e-f) $ 237,000
- Costs allocated to domestic production gross receipts (h=c) $ 195,000
- Qualified production activities income (g-h) $ 42,000
- Potential deduction for 2005 at 3%(i x 3%) $ 1,260
The safe harbor rule will save many home builders.
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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