Large swaths of the construction industry halted as a result of the COVID-19 pandemic adversely affecting timetables, profitability, and tax strategies.

As construction projects begin to pick up steam, often overlooked tax and contracting strategies may yield significant savings—both in budgeting for new developments and in recouping costs for completed or in-progress buildings.

Qualified Improvement Property

One tax strategy may entail the recent correction of an error in the tax code that now allows for immediate accelerated deductions, known as bonus depreciation, for qualified improvement property (QIP). This deduction previously had been stretched over 39 years prior to the change.

For more details, please see How Qualified Improvement Property Changes Can Create Cash Flow Benefits.

What constitutes QIP, and the way the new rules are applied, must be carefully considered—particularly in development.

Restrictions

Assume a developer is building a 100,000 square-foot building with spec tenant improvements or suites. The building structure and interior improvements—such as drywall, restroom fixtures, and lighting—generally wouldn’t be eligible for bonus depreciation and would be recovered over 39 years.

This means that if the interior improvements cost $1 million, the first-year depreciation would be less than $25,000.

Eligible Improvements

Let’s say the same developer is constructing the same building, but they decided to complete the building as a warm shell with limited interior improvements, placed it in service, and offered it for lease in that condition. Then, a separate contract with a general contractor for the interior was executed once a tenant or plans were finalized.

Because QIP is applicable to certain interior improvements constructed after a building is placed into service, the same assets recovered over 39 years in the initial scenario—drywall, restroom fixtures, and lighting—could be fully deductible for federal income-tax purposes.

In other words, the interior improvements that cost $1 million in the first scenario would be fully deductible. This provides an increase in depreciation over the first scenario of $975,000 and potentially reduces the developer’s tax bill by $292,500 at a 30% tax rate. State-tax conformity varies.

Effect on Cost

The substantial tax difference between these two scenarios—for what is essentially the same building—showcases the planning ramifications of tax strategies beyond the sequence of construction.

For example, tenant allowances may be fully deductible as QIP if they are spent on eligible improvements. Providing a substantial tenant allowance could be key to attracting tenants and negotiating favorable lease terms, while the upfront cash outlay can be mitigated if the tenant allowances allow for a substantial tax deduction for the lessor in the current year.

Special attention needs to be paid to the lease language, however, to ensure it’s structured to allow for ownership of the assets by the lessor, and tenant allowances would need to be spent on eligible assets.

It may also be beneficial to consult a contractor or outside adviser—such as a cost segregation specialist—because QIP is limited to interior and non-structural improvements. Contractors typically don’t distinguish costs between the exterior and interior on their invoices, and some assets have both interior and exterior components. An HVAC system, which can include both exterior rooftop units and interior ductwork, is probably the most common—and costly—example.

Contracting Strategies

Projects provide exciting opportunities for growth and prosperity, but they can also present significant challenges. Implementing smart contracting strategies along with clear tax strategies is critical to managing the following:

• Budgets
• Cost compliance
• Schedule
• Quality
• Stakeholder expectations

Specifically, contracting strategies need to include the following:

• Competitive bidding procedures
• Mindful contract-type selection
• Strong cost-of-work definitions

Competitive Bidding Procedures

It’s important to obtain comparative bids on contractor and subcontracted work to ensure competitive pricing for a complete project.

Requiring three bids is a good place to start. It offers an effective comparison between bidders to ensure cost competitiveness without being overly burdensome for either the contractor, owner, or developer.

It’s important to obtain comparative bids on contractor and subcontracted work to ensure competitive pricing for a complete project. Requiring three bids is a good place to start.

Mindful Contract-Type Selection

Contract-type selection can be as critical to managing budgets as competitive bidding procedures. Understanding the different available contract types can help increase transparency and accountability. The most common contract types include the following:

• Lump sum
• Time and materials
• Cost plus
• Cost plus: guaranteed maximum price (GMP)

Each contract type needs to be evaluated for appropriateness—especially with COVID-19 impacts and considerations—and aligned with a project’s scope and objectives.

Lump-sum contract types, if not properly procured, may include the following:

• Higher markups
• Increased change orders
• Inadequate material quality

Time-and-materials and cost-plus contract types that aren’t appropriately managed by an owner could encounter low productivity resulting in schedule delays and increased construction spend.

GMP contracts, on the other hand, might suffer from poor cost-of-work definitions that result in a lack of controls surrounding budget and cost.

Strong Cost-of-Work Definitions

Selecting strong cost-of-work definitions has many benefits when coupled with a GMP contract. A GMP contract allows owners and contractors to define adequate allowable and unallowable cost of work for a project, which helps both parties manage and control cost.

At the same time, cost-of-work definitions—with a right-to-audit clause—need to be sufficiently clear to enable the efficient validation of compliant project charges.

Engaging an experienced team of construction auditors can help align best practices with competitive-bidding procedures, contract-type selection, and cost-of-work definitions.

We’re Here to Help

For help implementing tax and contracting strategies to increase your real estate company’s tax savings, control project budgets, and achieve project goals, contact your Moss Adams professional.