As the examples below demonstrate, the results from using the two methods can vary significantly. Users of the two methods will also have to consider a third possible method, which may be used for financial reporting. The discussion here will exclude any consideration of that third possibility.

Example 1

Assume developer is a calendar-year, accrual-basis taxpayer, and buys raw land for $100,000 in January 1993. He plans to subdivide the land into 10 residential lots, make improvements, and sell the lots to builders. In February 1993, developer negotiates contracts with builders who agree to pay $80,000 per lot on the condition he construct sewers, streets, sidewalks, playgrounds, tennis courts, and a swimming pool. (Developer is obligated, by builders' contracts or local law, to provide common improvements. Such an obligation is a prerequisite to use the "alternative-cost method.")

In early 1993, developer prepares a budget for the estimated costs of these improvements. He plans to spend about $150,000 to install sewers, streets, and sidewalks; $250,000 to construct playgrounds and tennis courts; and $100,000 to install a swimming pool. These amounts will be spent in the following years:

YearAmount

1993$150,000

1994250,000

1995100,000

$500,000

The total cost of the project is $600,000: $100,000 (land) + $500,000 (improvements). If the 10 lots are identical in all important respects, and if the improvements benefit all lots equally, developer's cost per lot is $60,000: $10,000 for land and $50,000 for future improvements.

Assume developer sells four lots in 1993, four lots in 1994, and two lots in 1995. The revenue is summarized as follows:

Lots

YearSoldRevenue

19934$320,000

19944320,000

19952160,000

10$800,000

Developer's 1993 taxable income depends upon whether he used the "general method" or the "alternative-cost method."

Tax-General Method

Because developer is an accrual-basis taxpayer, the tax consequences with respect to liabilities depend upon both the all-events test and the economic-performance test. Under the all-events test IRC Sec. 461(h) (4), he has a tax consequence when 1) all events have occurred to create a liability and 2) the amount of the liability is determinable with reasonable accuracy. Under the economic performance test IRC Sec. 461(h) (2) (B), when he has an obligation to provide services or property in the future, he has a tax consequence when he actually provides such services or property.

In Example 1, in 1993, developer satisfies both tests by installing the sewers, streets, and sidewalks and by incurring $150,000 of costs. Consequently, he can use some of the $150,000 in figuring his 1993 taxable income. Under the general method, his 1993 taxable income is $220,000, as calculated below.

Sales$320,000

Costs100,000(1)

Income$220,000

(1)$40,000(land-$10,000x4)

(improvementcosts

60,000$150,000/10x4)

$100,000

The Alternative-Cost Method

Under the alternative-cost method, the economic-performance test is relaxed, so developer can accelerate future improvement costs into the present. To slow this acceleration, Rev. Proc. 92-29 imposes a limitation. "The alternative-cost limitation" provides, as of the end of any tax year, the total amount of future improvement costs taken into account may not exceed those that have been incurred for economic performance purposes. If the limitation precludes taking into account some future improvement costs, the disallowed amount is carried forward to subsequent years.

If developer in Example 1 uses the alternative-cost method, his 1993 taxable income, 1) without the limitation and 2) with the limitation, is calculated below:

WithoutWith

LimitationLimitation

Sales$320,000$320,000

Costs240,000(1)190,000(2)

Taxable

Income$80,000$130,000

(1)$40,000(Landcost-S10,000x4)

200,000(other-$50,000x4)

$240,000

(2)$40,000(landcost-$10,000x4)

(other-limitedtocosts

150,000incurredtodate)

$190,000

Under the general method, "costs" are $100,000, and the portion relating to common improvements is $60,000 ($150,000/ 10 x 4). Under the alternative-cost method, as limited, "costs" are $190,000, and the portion relating to common improvements is $150,000 (costs incurred in 1993).

The additional $90,000 results from a relaxation of the economic- performance test as it relates to the alternative-cost method. Even though the playgrounds, tennis courts, and swimming pool have not been constructed in 1993, $90,000 of their estimated costs are still drawn into 1993. The remaining $50,000 ($140,000 - $90,000) is carried forward and deducted in future years.

Example 2

Same facts as Example 1, except the four lots are sold and playgrounds and tennis courts ($250,000) are constructed in 1994. Developer's taxable income is $20,000 under the general method and $30,000 under the alternative-cost method, as calculated below:

GeneralAlternative

Sales$320,000$320,000

Costs300,000(1)290,000(2)

Taxable

Income$20,000$30,000

(1)$40,000(landcost-$10,000x4)

60,000(other-1993-$150,000/10x4)

200,000(other-1994-$250,000/10x8)

$300,000

(2)$40,000(landcost-$10,000x4)

200,000(other-$500,000/10x4)

50,000(1993costsdisallowed)

$290,000

In 1994, the alternative-cost limitation is $400,000 which represents the maximum deduction that can be taken over the two-year period. Since developer was limited to $150,000 in 1993, he can take $250,000 ($400,000 - $150,000) of estimated future improvement costs in 1994. This $250,000 represents developer's 1994 "Annual Deduction."

Example 3

Same facts as Example 1, except the year is 1995 when two lots are sold and the swimming pool ($100,000) is constructed. Developer's taxable income is a negative $40,000 trader the general method and a positive $40,000 under the alternative-cost method, as calculated below:

GeneralAlternative

Sales$160,000$160,000

Costs200,000(1)120,000(2)

Taxable

Income($40,000)$40,000

(1)$20,000(landcost-$10,000x2)

30,000(other-1993-$150,000/10x2)

50,000(other-1994-$250,000/10x2)

100,000(other-1995-$100,000/10x10)

$200,000

(2)$20,000(landcost-$10,000x2)

100,000(other-$500,000/10x2)

$120,000

In 1995, the alternative cost limitation is $500,000 which represents the maximum deduction that can be taken over the three-year period. Since developer took $150,000 in 1993 and $250,000 in 1994, he can take $100,000 $500,000 ($150,000 + $250,000) in 1995. This $100,000 represents developer's 1995 "annual deduction."

Comparing Tax Results

The following is a comparison of taxable incomes, by method, for the three-year period:

YearGeneralAlternative

1993$220,000$130,000

199420,00030,000

1995(40,000)40,000

Aggregate

Taxable

Income$200,000$200,000

Over the three-year period, aggregate taxable income under either method is the same. This does not mean, however, that developer is indifferent as to which method he uses. His individual circumstances will dictate the appropriate method. For example, if his tax rate is falling, developer would prefer the alternative-cost method because it postpones income to the future. On the other hand, if his tax rate is rising, developer would prefer the general method because it accelerates income into the present. If his tax rate is constant, developer would prefer the alternative-cost method because of the time-value of money. As a general rule, most developers will prefer the alternative-cost method.

Change in Estimated Costs

Developer's actual costs may vary from those originally estimated. This variance will cause prior years' cost figures to be either understated or overstated. If the variance arises in a subsequent year, developer may not adjust prior years' returns. Instead, he must make an adjustment in the year the variance arises.

Example 4

Same facts as Example 1, except the estimated future improvement costs of sewers, streets, and sidewalks is $250,000 (instead of $150,000) and the costs of playgrounds and tennis courts is $150,000 (instead of $250,000). The new expenditures are summarized below:

1993$250,000

1994150,000

1995100,000

$500,000

If developer uses the alternative-cost method, his 1993 taxable income is $80,000, as calculated below:

Sales$320,000

Costs240,000(1)

TaxableIncome$80,000

(1)$40,000(landcost-S10,000x4)

200,000(other-$500,000/10x4)

$240,000

This is the same amount calculated in Exhibit 1 without the limitation. The limitation no longer applies because of the change in facts whereby $250,000 is spent in 1993 vs. $150,000 in the previous example.

Example 5

Same facts as Example 4, except the four lots are sold, and playgrounds and tennis courts are constructed in 1994. If developer incurred $150,000 as originally planned, his 1994 taxable income still would be $80,000, as calculated in Example 4. Assume, however, developer incurs $180,000, rather than $150,000. This $30,000 variance results in "Additional Deductions" of $24,000 in 1994 and $6,000 in 1995, as shown below:

RevisedAdditional

YearCostsDifferenceDeduction

1993$212,000(1)$12,000(2)

1994212,000(1)12,000$24,000(3)

1995106,000(4)6,0006,000

$530,000$30,000$30,000

(1)$530,000/10x4=$212,000:retroactivelyrevisedfiguredueto1994cost

overrun

(2)Noadditionaldeductionbecausedevelopernotpermittedtoamendprior

year'sreturn.

(3)Cumulativeeffectofchangemustbeaccountedforin1994--yearvariance

arises.

(4)$530,000/10x2=$106,000:revisedfiguredueto1994costoverrun

Because of the additional deduction of $24,000 in 1994, developer's 1994 taxable income under the alternative-cost method is $56,000, as calculated below:

Alternative

Cost

Sales$320,000

Costs264,000(1)

TaxableIncome$56,000

(1)$40,000(landcost-$10,000x4)

212,000(other-530,000/10x4)

12,000(portionofchangerelatingto1993)

$264,000

Prerequisites for the Alternative-cost method

To use the alternative-cost method, developer must follow certain procedures. He or she must file a request to use this method on a project-by-project basis with the District Director of the IRS. The request must be filed on or before the due date (including extensions) of the original tax return for the tax year in which the first property is sold. Information such as common improvements, estimated costs, and other matters must be included in the request. A copy of the request also should be attached to the timely filed tax return. A supplemental request must be filed, if, for a valid reason, developer is unable to complete the common improvements within the originally anticipated time frame.

The developer must agree to extend the statute of limitations on the assessment of income tax for each tax year in which the alternative-cost method is used. The extension is for the expected duration of the project, plus one year.

The developer must file an annual statement with the District Director for each project for which permission to use the alternative-cost method has been received. The statement should include information such as an update of estimated costs, a description of the manner in which estimated costs have been allocated, and the number of lots sold.