How to Account for Incidental Revenues and Expenses During Construction
For property owners that are looking to develop residential or commercial real estate for the purpose of generating rental income, we often come across questions such as:
- How do I account for revenues and expenses resulting from incidental operations prior to the completion of the income-producing properties?
- How does the accounting treatment of these incidental revenues and expenses differ from their tax treatment?
In this article we will address both the accounting and tax treatments of these types of incidental revenues and expenses.
WHAT ARE INCIDENTAL REVENUES AND EXPENSES?
To construct an income-producing property, a property owner will go through various stages of the development cycle, including planning, applying for permits, going through public consultation, getting the approvals, obtaining the necessary financing, construction, etc. As the development period can be quite lengthy, the property owner will often generate revenues from the property through other activities while it works through the development process. The revenues and expenses resulting from the operation of the property are incidental, or separate, from any of the development activities.
Some of the more common incidental operations include:
- A property owner continuing to rent out units in an office building that is subject to demolition and redevelopment, which will ultimately be replaced with a condominium. To continue renting out these units, expenses such as utilities and maintenance costs for the tenants will need to be incurred.
- An owner of a piece of bare land using the empty space as a paid parking lot while awaiting the construction permit. To use the bare land as a parking lot, expenses such as property taxes and permit fees will be required.
WHAT IS THE ACCOUNTING TREATMENT?
The general accounting rule is that incidental revenues and expenses prior to the completion date of an income-producing property should be included in the cost of the property (i.e. capitalized). In situations where the incidental revenues exceed the operating expenses, there would be a reduction in the carrying costs of the property under construction. In situations where incidental expenses exceed the revenues, there would be an increase in the carrying costs of the property under construction. This may be helpful to investors, as they generally would not see costs over a long construction period as losses, but rather as increased carrying costs of the property.
The determination of the completion date of an income-producing property can be quite complex and have a significant effect on the accounting treatment of these revenues and expenses. There are also practical concerns regarding the accounting of incidental revenues and expenses that should be considered. If you have any questions regarding the accounting for incidental revenues and expenses, please contact get in touch with us.
WHAT IS THE TAX TREATMENT?
The tax treatment differs from the accounting treatment for incidental revenues and expenses. For accounting purposes, the incidental revenues and expenses are included in the cost of the property and thus are not shown on the income statement as either net income or loss. For tax purposes, revenues earned from incidental operations are generally subject to taxation. However, there are provisions in the Income Tax Act that allow certain expenses to be deducted against these revenues in order to reduce net income that would otherwise be taxed. It is important to note that there are also provisions in the Income Tax Act whereby the amount of expenses deductible for tax purposes is limited by the amount of revenues subject to taxation. The following example is a simplified illustration:
As illustrated above, $10,000 of expenses can be deducted against incidental rental revenues, which would then reduce the net rental income from incidental operations to $nil. Deductible expenses are limited by the revenues from incidental operations such that no loss can be reported for income tax purposes. Therefore, proper tax planning is required to determine which expenses should be deferred in order to limit incidental expenses to the amount of incidental revenues earned throughout the development period.
The information presented above is not meant to be a comprehensive discussion of the accounting and tax reporting requirements for incidental revenues and expenses. If you have any questions regarding incidental revenues and expenses, please visit our Real Estate & Construction page on our website or contact us directly and we can put you in touch with the right advisor to help you and your organization succeed.