Determining the cost basis of new construction is not as straightforward as it seems. In addition to direct costs, indirect costs may also be required to be capitalized as part of the building. Indirect costs include expenditures such as: taxes related to labor and materials, insurance related to construction, and interest incurred during construction period. One of the most overlooked and misunderstood indirect costs is the borrowing and finance costs associated with obtaining a construction loan. These loan origination fees are generally charged by the lender for putting the loan into service, processing the application and establishing an account, along with other administrative costs. The fees typically range from .5% to 2% of the principal amount of the loan, so they can be significant for larger construction projects.
Typically, a loan origination fee incurred to obtain a construction loan is amortized over the life of the loan. This also seems very straightforward; however, facts and circumstances may result in different treatment. For example, if the loan fees were initiated in the year the entity was organized, a portion of the loan may have been used to establish the entity and considered a start-up expense. Up to $5,000 of these costs may be deducted in the initial year. However, the deductible amount is phased out by costs exceeding $50,000, and any remaining amounts are required to be amortized over 180 months. Not all expenses related to a new loan must be capitalized. Prepayment penalties and premiums paid to retire a bond issued in connection with the loan are generally deducted the year they are paid or incurred. In some cases, the financing fee is actually an additional cost of borrowed money, and these costs can be deducted as interest expense as incurred.
Loans can be structured in a way to reduce the amortization period and recover the tax benefit over a shorter period of time. For example, a single construction project may require multiple loans. The borrower may use a construction loan in order to finance the construction period, which generally has a shorter amortization period than permanent financing of the project. In order to take advantage of the shorter construction period amortization, the borrower must be able to substantiate separate loans such as separate loan applications, different interest rates at the time of the loan, separate loan terms, and separate closing documents. If there is insufficient evidence that the loans are independent of one another, the borrower may be subject to the longer amortization period.
As discussed above, the accounting and tax treatment of loan origination and borrowing costs can be very complex, but with proper planning and advice, the period to recover these costs can be shortened. Contact us if you have any questions on determining the proper treatment of these costs on your new loan and visit our construction services page to learn about the different services that we offer to the the industry.