IRS Revenue Ruling
2002-9

 Code Secs. 263A, 42, 167, 168, 263, 446 ....

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26 CFR 1.263A-1: Uniform capitalization of costs.
(Also sections 42, 167, 168, 263, 446, 481; 1.263(a)-1.)

Impact fees. This ruling provides that impact fees incurred by a
taxpayer in connection with the construction of a new residential rental
building are capitalized costs allocable to the building.


REV. RUL. 2002-9

ISSUE

Are "impact fees" incurred by a taxpayer in connection with the
construction of a new residential rental building capitalized costs
allocable to the building under sections 263(a) and 263A of the Internal
Revenue Code?


FACTS

Taxpayer is in the business of developing, owning, and leasing
residential rental property. Taxpayer purchased unimproved land located in
County on which Taxpayer will construct a new residential building that it
will rent to tenants. The development plan submitted by Taxpayer to County
indicates that the building is expected to have x number of rental units.
County imposes "impact fees" on new and expanded development.

Impact fees are one-time charges that are imposed by a state or local
government against new development or expansion of existing development to
finance specific offsite capital improvements for general public use that
are necessitated by the new or expanded development. Generally, impact
fees are refundable (in full or in part) if the new or expanded
development ultimately is not constructed as planned.

Taxpayer was required by County to pay various impact fees (for
example, for schools and law enforcement and fire protection facilities)
in order to compensate County for the financial impact of Taxpayer's new
building. These impact fees were calculated based on Taxpayer's projection
of the number of rental units in, and on the size of, the building.
Taxpayer paid the impact fees when the construction permit for the
building was issued.


LAW AND ANALYSIS

Section 263(a) and section 1.263(a)-1(a) of the Income Tax Regulations
provide that no deduction is allowed for any amount paid out for new
buildings or for permanent improvements or betterments made to increase
the value of any property or estate. Section 1.263(a)-2(a) provides that
capital expenditures include the cost of acquisition, construction, or
erection of buildings, machinery and equipment, furniture and fixtures,
and similar property having a useful life substantially beyond the taxable
year.

Section 263A provides, in part, that direct costs and a properly
allocable portion of indirect costs of real or tangible personal property
produced by a taxpayer must be capitalized to the property produced. See
also section 1.263A-1(a)(3)(ii). Section 263A(g)(1) provides that the term
"produce" includes construct, build, install, manufacture, develop, or
improve. See also section 1.263A-2(a)(1)(i). Property produced may include
land, buildings, land improvements, and other tangible property owned by
the taxpayer for federal income tax purposes. See section
1.263A-2(a)(1)(ii). Section 1.263A-2(a)(3)(i) provides that any cost
required to be capitalized by section 263A must be capitalized regardless
of whether the cost was incurred before, during, or after production.

Section 1.263A-1(e) provides rules for determining the direct and
indirect costs that are required to be capitalized to property produced.
Section 1.263A-1(e)(2)(i) provides that direct costs consist of direct
material and direct labor costs. Section 1.263A-1(e)(3)(i) defines
indirect costs as all costs other than direct material costs and direct
labor costs. Indirect costs are properly allocable to property produced
when the costs directly benefit, or are incurred by reason of, the
performance of production activities. Indirect costs that are allocable to
production activities then must be allocated among the properties
produced. See section 1.263A-1(f).

In Oriole Homes Corp. v. U.S., 705 F. Supp. 1531 (S.D. Fla. 1989), the
court held that road, educational, regional park, and municipal park
impact fees required for the approval and recordation of plats for
subdivisions are capital expenditures, to be capitalized as a development
cost and deducted pro rata as each house is sold. In reaching its holding,
the court stated that "the impact fees increased the value of the
subdivisions and secured a benefit which lasted beyond the taxable year in
which they were incurred." Similarly, the impact fees incurred by Taxpayer
resulted in a permanent improvement or betterment to Taxpayer's
development project. Accordingly, consistent with Oriole Homes, the impact
fees incurred by Taxpayer must be capitalized to the property produced
under section 263(a).

Moreover, because Taxpayer's development project constitutes production
of property within the meaning of section 263A(g)(1), Taxpayer is required
to capitalize under section 263A the direct costs and a proper share of
the allocable indirect costs associated with the development. In Von-Lusk
v. Commissioner, 104 T.C. 207 (1995), the court held that certain expenses
incurred by a real estate developer before actual physical work began on
undeveloped land are subject to section 263A. The court found that the
developer's activities, such as obtaining building permits and zoning
variances, negotiating permit fees, and similar activities, represent the
"first steps in the development of the property." The court further noted
that the pursuit of building permits and zoning variances, negotiating
permit fees, and similar activities "are ancillary to actual physical work
on the land and are as much a part of a development project as digging a
foundation or completing a structure's frame. The project cannot move
forward if these steps are not taken."

The impact fees incurred by Taxpayer are not direct costs within the
meaning of section 263A because they are neither direct material nor
direct labor costs. However, the impact fees are indirect costs under
section 263A because they directly benefit, and are incurred by reason of,
Taxpayer's production activity. Similar to the costs at issue in Von-Lusk,
the impact fees were assessed by County because of Taxpayer's plans to
construct the new residential building, and thus are "as much a part of a
development project as digging a foundation or completing a structure's
frame." Thus, in accordance with section 1.263A-1(f), Taxpayer must
allocate the impact fees to the property produced based on all the facts
and circumstances. Because the impact fees are assessed as a result of
Taxpayer's plans to construct the building, the amount of the impact fees
is calculated based upon the characteristics of the building, and the
impact fees generally would be refundable if Taxpayer decides not to
construct the building as planned, the impact fees are allocable to the
building. Accordingly, the impact fees must be capitalized under section
263A as indirect costs allocable to the new residential rental building.


HOLDING

"Impact fees" incurred by a taxpayer in connection with the
construction of a new residential rental building are capitalized costs
allocable to the building under sections 263(a) and 263A.


APPLICATION

Any change in a taxpayer's treatment of impact fees incurred in
connection with the new construction or expansion of a building to conform
with this revenue ruling is a change in method of accounting to which the
provisions of sections 446 and 481 and the regulations thereunder apply.

A taxpayer wanting to change the method of accounting for impact fees
to conform with this revenue ruling must follow the automatic change in
method of accounting provisions in Rev. Proc. 2002-9 (2002-3 I.R.B. 327)
(or its successor), as modified and clarified by Announcement 2002-17
(2002-8 I.R.B. 561), with the following modifications:

(1) If the taxpayer changes its method of accounting for impact fees to
conform with this revenue ruling for the first taxable year ending on or
after December 31, 2001, the scope limitations in section 4.02 of Rev.
Proc. 2002-9 do not apply; and

(2) To assist the Internal Revenue Service in processing changes in
method of accounting under this revenue ruling, and to ensure proper
handling, section 6.02(4)(a) of Rev. Proc. 2002-9 is modified to require
that a Form 3115 filed under this revenue ruling include the statement
"Automatic Change Filed Under Rev. Rul. 2002-9." This statement should be
legibly printed or typed on the appropriate line on the Form 3115.

If a taxpayer changes its method of accounting for impact fees to
conform with this revenue ruling, the treatment of impact fees will not be
raised as an issue in any taxable year before the year of change,
consistent with the audit protection provision of section 7.01 of Rev.
Proc. 2002-9. If this change in method of accounting is made for the
taxpayer's first taxable year ending on or after December 31, 2001, and
the treatment of impact fees has already been raised as an issue in a
taxable year before the taxpayer's first taxable year ending on or after
December 31, 2001, the treatment of impact fees will not be further
pursued.

If a depreciation deduction is allowable under section 167(a) for the
building and it is subject to section 168, the taxpayer must depreciate
the impact fees under section 168 as residential rental property or
nonresidential real property (as both are defined in section 168(e)(2)),
as appropriate, beginning when the newly constructed building or the
expansion of the building is placed in service by the taxpayer. Moreover,
for purposes of section 42, impact fees are included in the eligible basis
of a qualified low-income building. A change in method of accounting for
impact fees to conform to this revenue ruling does not affect the amount
of credit that has been allocated under section 42(h)(1) or allowed for
buildings financed with tax-exempt bonds subject to the volume cap as
determined under section 42(h)(4).


EFFECT ON OTHER DOCUMENTS

Rev. Proc. 2002-9 is modified and amplified to include this accounting
method change in section 4 of the APPENDIX.


DRAFTING INFORMATION

The principal authors of this revenue ruling are Kathleen Reed and
Christopher J. Wilson of the Office of Associate Chief Counsel
(Passthroughs and Special Industries). For further information regarding
section 42, 167, or 168, contact Gregory Doran at (202) 622-3040 or Mr.
Wilson at (808) 539-2874. For further information regarding section 263(a)
or 263A, contact Cheryl L. Oseekey at (202) 622-4970. These are not
toll-free calls.

<<END RULING>>

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