Real Estate Developers and Construction Firms May Be Missing Out on Section 199 Deduction Opportunities, by Karen A. Lake, CPA
Posted on September 24, 2015
While the Section 199 domestic manufacturing deduction has been in effect since 2005, few real estate developers and construction contractors understand if they qualify for the deduction and how they may realize the significant tax benefits associated with it.
Under the Internal Revenue Code, taxpayers actively involved in the trade or business of construction, architectural design and engineering of real property in the U.S. may offset income with a fully phased in tax deduction of 9 percent on profits from qualified activities. Determining what activities qualify for the deduction can be both challenging and time consuming. However, taking the time to understand the components that qualify for Section 199 deductions and analyzing and substantiating the qualifying costs could prove to be a valuable effort.
Do You Qualify as a Construction Business?
To qualify for a Section 199 deduction, contractors must meet the following requirements:
- Be engaged in “construction”,
- Be involved in the construction of “real property” in the U.S.,
- Be actively engaged in a construction trade or business on a regular and ongoing basis,
- Have gross receipts that derive from construction activities
More specifically, the IRS defines construction as “activities performed to erect or substantially renovate real property in the U.S.” This may include renovations to major components or structural parts of real property that material increase the property’s value, prolongs its use or converts it for a completely different use. It may also include some managerial functions conducted by general contractors in the normal course of business.
Real property refers to both residential and commercial buildings as well as the structural components and permanent structures that will eventually become a part of the total project. This may include parking lots, club houses, tennis courts and swimming pools, as well as the roads, sidewalks, and water and sewer lines that support the property’s infrastructure.
To meet the requirements of active engagement in a construction trade or business, taxpayers must be involved with the regular and ongoing sale of constructed property to an unrelated purchaser within five years of project completion. However, to qualify for the Section 199 deduction, taxpayers need not be licensed general contractors nor must the work they perform on a particular project be their only source of income.
Do You Have Qualifying Domestic Production Gross Receipts?
The definition of construction activities can become muddled when considering that it does not always cover specific services performed by anyone other than the builder. For example, excluded from Domestic Production Gross Receipts (DPGR) are peripheral services, such as hauling debris and delivering materials, unless the taxpayer performs those services in connection with the construction project. The same holds true for general improvements, such as demolition, excavation, landscaping and painting, unless the taxpayer performs these services in conjunction with a building or renovation project.
Determining what income derived from construction qualifies for Section 199 deductions requires careful review and itemization of a taxpayer’s gross receipts. Income from gross proceeds from property sales and contract services as well as a contractor’s mark-up on materials used in the project and a permanent part of the finished project may be used to calculate the deduction. Alternatively, income from non-construction activities, such as the value of the land and gross proceeds from the sale of re-acquired property that the taxpayer originally constructed, is excluded from the deduction calculation. Furthermore, general contractors and subcontractors are often surprised to learn that they may take the Section 199 deduction on the same project when the subcontractor’s gross receipts match the general contractor’s costs.
Before applying, calculating and substantiating Section 199 deductions, taxpayers must recognize and analyze a range of additional planning opportunities that can affect a reduction in their tax rates. For example, the amount of the deduction in a tax year may not exceed the taxpayer’s taxable income. Furthermore, because the deduction is limited to 50 percent of W-2 wages paid in the fiscal year, a sole-proprietor with no employees may not claim the domestic production/manufacturing deduction.
Similarly, many construction-related entities have complex structures that can affect the application and amount of Section 199 deductions. For example, pass-through entities may apply the deduction only at the partner/shareholder level, unlike large partnerships and joint ventures, which will have a completely different deduction calculation.
Applying the Section 199 deduction is not a simple endeavor. Yet, it is often worth the effort, especially when considering it typically saves qualifying U.S. businesses in excess of $110 billion over 10 years, according to the U.S. Chamber of Commerce. Partnering with an accounting firm experienced in real estate development matters can ease the burden and ultimately help builders and contractors realize the untapped tax saving unique to their industry.
About the Author: Karen A. Lake, CPA, is an associate director of Tax Services with Berkowitz Pollack Brant and a specialist in Federal and State and Local Tax (SALT) credits and incentives. She can be reached in the Miami CPA firm’s Miami office at 305-379-7000 or via email at email@example.com.