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In addition to the general considerations for capitalization discussed in PPE 1.2, reporting entities constructing assets for sale or rental should consider the additional guidance provided by ASC 970-360 and ASC 970-340. The guidance in ASC 970-360 and ASC 970-340 is specific to reporting entities in the real estate industry that are in the business of constructing assets for sale or rental. Factors to consider in assessing whether a capital project was built for sale or rental are summarized in Figure PPE 1-4.
Not all of the factors in Figure PPE 1-4 are required to be present to conclude that a capital project was built for sale or rental; however, to reach such a conclusion, a long-term lease or sales agreement should generally be part of the initial design and expected use of the capital project. The existence of a short-term lease could also result in a conclusion that construction is for the purpose of sale or rental if the reporting entity has the intent and ability to renew the lease or subsequently enter into a similar agreement with another party.
Figure PPE 1-4
Evidence supporting construction for sale or rental versus entity’s own use
Sale or rental
Reporting entity’s own use
• Capital project is subject to lease through a long-term purchase agreement
• Capital project will be operated to serve retail customers
• Capital project will be sold or leased again at the end of the lease term
• Capital project is subject to only a short-term lease (typically less than five years) with no expectation to continue leasing
• Capital project is constructed for purpose of immediate sale; signed sales agreement is in place
• Capital project is designed for the owner’s use

1.7.1 Internal property acquisition costs (real estate)

PPE 1.2.1.2 discusses the accounting treatment for costs incurred during the pre-acquisition stage. ASC 970-340 provides additional guidance regarding the accounting for internally generated pre-acquisition costs. ASC 310-20-55-9 and ASC 310-20-55-10 provide guidance on distinguishing between internal and external costs (i.e., costs related to independent third parties). Pre-acquisition costs can be incurred for the purpose of, but prior to, obtaining a real estate property. Examples of pre-acquisition costs include costs of surveying, zoning or traffic studies.
ASC 970-340-25-6 requires capitalization of internal pre-acquisition costs related to the acquisition of a property that will be classified as nonoperating at the date of acquisition (e.g., a property under construction that is not yet available for occupancy) if the costs are directly identifiable with the acquired property and if they were incurred subsequent to the time that acquisition of the property was considered probable. Internal pre-acquisition costs related to the acquisition of a property that will be classified as operating upon acquisition (e.g., a property on which significant construction activity will be completed and the property will be ready for occupancy, or a property that is already income producing) should be expensed as incurred. If portions of property are in different stages of completion, then substantially completed sections should be accounted for as a separate project and costs incurred allocated between projects (see ASC 970-340-25-17).
If a reporting entity determines that a property to be acquired that was originally expected to be classified as nonoperating will be classified as operating at the date of acquisition, previously capitalized internal pre-acquisition costs should be charged to expense and any additional costs expensed as incurred. However, if the reporting entity initially determined that a property would be classified as operating and subsequently determines that the property will be classified as nonoperating at the date of acquisition, the internal pre-acquisition costs that were previously expensed should not be capitalized.
The guidance in ASC 970-340 related to internal acquisition costs does not address the accounting for internal acquisition costs associated with business combinations. Under ASC 805-10-25-23, acquisition costs related to a business combination should be expensed as incurred.

1.7.2 Capitalized interest, taxes, and insurance (real estate)

Property taxes and insurance costs are capitalized during the period activities are being performed to get the property ready for sale or rental and until the property is substantially complete. Per ASC 970-340-25-8, for purposes of capitalizing real estate taxes and insurance, the criteria for determining the period of capitalization should follow that used for capitalizing interest costs.
As discussed in ASC 835-20-25-3(b), capitalization should begin when (among other criteria) activities that are necessary to get the asset ready for its intended use are in progress. As indicated in ASC 835-20-20, the term “activities” is to be construed broadly and is not limited to actual construction activities. It includes all the steps required to prepare an asset for its intended use.
Under ASC 835-20-25-5, the interest capitalization period should cease no later than at the point the building is ready for its intended use, irrespective of whether the space has been leased. Capitalization of property taxes and insurance should cease at the same time as interest capitalization as stated in ASC 970-340-25-8.

Excerpt from ASC 970-340-25-8

The phrase substantially complete and ready for its intended use is used here with the same meaning as it has for interest capitalization in paragraph ASC 835-20-25-5.

See PPE 1.3 for further discussion regarding capitalized interest.

1.7.3 Indirect costs (real estate)

Indirect costs can be capitalized if an asset is constructed for sale or rental. If constructed for the reporting entity’s own use, indirect costs would not be capitalizable. Indirect costs are defined in ASC 970-360-20.

Definition from ASC 970-360-20

Indirect Projects Costs: Costs incurred after the acquisition of the property, such as construction administration (for example, the costs associated with a field office at a project site and the administrative personnel that staff the office), legal fees, and various office costs, that clearly relate to projects under development or construction. Examples of office costs that may be considered indirect project costs are cost accounting, design, and other departments providing services that are clearly related to real estate projects.

Reporting entities constructing property for sale or rental should have specific policies for the accumulation and capitalization of qualifying indirect costs. Indirect costs that do not clearly relate to projects under development or construction should be charged to expense as incurred. When defining and identifying the costs to be capitalized, the reporting entity should consider whether specific information is available (such as timecards) to support the allocation of overhead costs to specific projects. Furthermore, the costs incurred should be incremental costs. That is, in the absence of the project or projects under development or construction, these costs would not be incurred. It may be difficult to distinguish between indirect project costs and other costs (e.g., general and administrative expenses). When it is unclear, there is a general presumption they are not indirect project costs and would be expensed as incurred.
Indirect project costs that relate to a specific project, such as costs associated with a project field office, should be capitalized as a cost of that project. Other indirect project costs that relate to several projects, such as the costs associated with a construction administration department, should be capitalized and allocated to the projects to which the costs relate.

1.7.4 Amenities (real estate)

Amenities are common in many real estate projects. Examples of amenities include, golf courses, utility plants, clubhouses, swimming pools, tennis courts, indoor recreational facilities, and parking facilities. The accounting for the cost of amenities is based on management’s plans for the amenities, as described in ASC 970-340-25-9.

ASC 970-340-25-9

Accounting for costs of amenities shall be based on management's plans for the amenities in accordance with the following:
  1. If an amenity is to be sold or transferred in connection with the sale of individual units, costs in excess of anticipated proceeds shall be allocated as common costs because the amenity is clearly associated with the development and sale of the project. The common costs include expected future operating costs to be borne by the developer until they are assumed by buyers of units in a project.
  2. If an amenity is to be sold separately or retained by the developer, capitalizable costs of the amenity in excess of its estimated fair value as of the expected date of its substantial physical completion shall be allocated as common costs. For the purpose of determining the amount to be capitalized as common costs, the amount of cost previously allocated to the amenity shall not be revised after the amenity is substantially completed and available for use. A later sale of the amenity at more or less than its estimated fair value as of the date of substantial physical completion, less any accumulated depreciation, results in a gain or loss that shall be included in net income in the period in which the sale occurs.

Before an amenity is substantially completed and available for use, its operating income (or loss) should be included as a reduction of (or an addition to) common costs. When an amenity to be sold separately or retained by the developer is substantially completed and available for use, results of the amenity’s operations should be included in current operating results.

1.7.5 Ground lease expense (real estate)

ASC 842-10-55-21 provides specific guidance on the accounting for ground lease expense by a lessee during construction. This guidance prohibits a reporting entity from capitalizing such amounts in property constructed for a reporting entity’s own use. However, this guidance is not applicable to real estate projects constructed for the purpose of sale or rental. Consistent with the guidance under ASC 970, we believe that ground lease expense during the construction period can be capitalized for projects built for sale or rental.

Excerpt from ASC 970-340-35-2

Topic 842 does not address whether a lessee that accounts for the sale or rental of real estate projects under Topic 970 should capitalize rental costs associated with ground and building leases.

1.7.6 Governmental and other agencies costs (real estate)

As discussed in PPE 1.2.1.3, certain direct costs to make improvements required by a governmental or other regulatory authority in order to complete a development project, whether in the form of providing the improvements to the county or paying the county to make the improvements themselves, are capitalizable as an element of the construction cost of the development. These costs would be considered incremental costs directly associated with development and should be capitalized as part of the cost of the facility; this is consistent with ASC 970-360-25-2.
Furthermore, the reporting entity may be required to donate real estate for uses that benefit the project; these costs should be allocated as common costs of the project as discussed in ASC 970-360-35-1.

ASC 970-360-35-1

Real estate donated to municipalities or other governmental agencies for uses that will benefit the project are not abandonments. The cost of the real estate donated shall be allocated as a common cost of the project.

1.7.7 Incidental operations (real estate)

Incidental operations are revenue producing activities incurred during the holding or development period, the purpose of these activities is to reduce the cost of developing the property for its intended use. This would not include activities related to the intended use of the property. The guidance related to incidental operations does not include activities related to amenities, the guidance for amenities is discussed in PPE 1.7.4.
Consistent with the guidance in ASC 970-340-25-12, incremental revenue from incidental operations in excess of incremental costs should be accounted for as a reduction of capitalized project costs. Any incremental costs exceeding incremental revenues should be charged to expense as incurred because the incidental operations did not achieve the objective of reducing the cost of developing the property for its intended use. It should be noted that incremental costs include only those costs incurred because of incidental operations. Interest, taxes, security, and similar costs that are incurred during the development of project and regardless of the incidental operations are not considered to be incremental costs.

1.7.8 Development and construction cost allocation (real estate)

Real estate project costs, such as pre-acquisition costs, indirect project costs, development and construction costs, amenities, property taxes, and insurance, are assigned to individual components of the project based on specific identification, when practical. If specific identification is not practical, capitalized costs should be allocated as described in ASC 970-360-30-1.

ASC 970-360-30-1

The capitalized costs of real estate projects shall be assigned to individual components of the project based on specific identification. If specific identification is not practicable, capitalized costs shall be allocated as follows:
  1. Land cost and all other common costs, including the costs of amenities to be allocated as common costs per paragraphs ASC 970-340-25-9 through 25-11 (before construction), shall be allocated to each land parcel benefited. Allocation shall be based on the relative fair value before construction.
  2. Construction costs shall be allocated to individual units in the phase on the basis of relative sales value of each unit.
If allocation based on relative value also is impracticable, capitalized costs shall be allocated based on area methods (for example, square footage) or other value methods as appropriate under the circumstances.

Real estate projects are often developed and the units sold out over a period of years. In large projects, common costs that are allocated to all units, such as the cost of roads and sewer treatment plants, may not be incurred until several years after units begin to be sold. For accounting purposes, such costs should be allocated to individual units and are therefore costs of sales (assuming the developer can provide reasonable estimates of the costs to be incurred in the future).
The determination of the amount of costs to be capitalized (e.g., interest, property taxes) and the allocation of common costs (e.g., roads, infrastructure development) is in part dependent on how projects or phases within a development are defined. The guidance in ASC 970-360-20 should be considered when determining the distinguishable portions of a real estate project or phase. For example, a planned residential community may be geographically divided in half by a highway. The developer may plan to begin construction on the east side and move to the west side when the east has been substantially sold out. If the entire development is defined as a single project, both the east and west sides would be, assuming they met the requirements, qualifying assets for purposes of interest capitalization. If, however, each side was considered a separate project and "activities," as defined by ASC 835-20-20, were only underway on the east side, the west side would not be considered a qualifying asset. This would require a relative fair value allocation to the east and west sides for purposes of determining the east side qualifying asset amount. As the scope of a project is expanded and the period of development extended, a reporting entity’s ability to estimate future costs to complete becomes more critical. Estimates and cost allocations should be reviewed at the end of each financial reporting period as discussed in ASC 970-340-35-1.

ASC 970-340-35-1

Estimates and cost allocations shall be reviewed at the end of each financial reporting period until a project is substantially completed and available for sale. Costs shall be revised and reallocated as necessary for material changes on the basis of current estimates. Changes in estimates shall be reported in accordance with paragraphs ASC 250-10-45-17 through 45-20 and 250-10-50-4.

1.7.9 Costs incurred to sell or rent real estate

Following the adoption of ASC 606, costs incurred to sell real estate projects (e.g., model units and their furnishings, sales facilities, advertising, sales salaries) should be evaluated for capitalization following the guidance in ASC 340-40-25-1 though ASC 340-40-25-8. For further details on contract costs, see RR 11.
Costs incurred to rent real estate projects (e.g., model units and their furnishings, rental facilities, advertising, rental salaries) should be evaluated for capitalization following the guidance in ASC 970-340-25-16.

ASC 970-340-25-16

If costs incurred to rent real estate projects, other than initial direct costs, under operating leases or direct financing leases are related to and their recovery is reasonably expected from future rental operations, they shall be capitalized. Examples are costs of model units and their furnishings, rental facilities, semipermanent signs, grand openings, and unused rental brochures. Costs that do not meet the criteria for capitalization shall be expensed as incurred, for example, rental overhead. Initial direct costs are defined in Topic 842 and the accounting for initial direct costs is prescribed in that Topic.

The guidance in ASC 970-340 does not apply to the accounting for initial direct costs, which is included in ASC 842. Prior to adoption of ASC 842, the guidance related to initial direct costs is included in ASC 310 and ASC 840-20. Under ASC 842, initial direct costs are defined as incremental costs of a lease that would not have been incurred if the lease had not been obtained. See LG 4 for details regarding the accounting for initial direct costs under ASC 842.
As discussed in ASC 970-340-35-2, capitalized rental costs directly related to a lease should be amortized over the term of the lease. Capitalized rental costs not directly related to a lease should be amortized over the period of expected benefit. The amortization period should begin when the project is substantially complete and held available for occupancy.

1.7.10 Changes in use and demolition considerations (real estate)

ASC 970-360-35-2 provides additional guidance related to capitalization of costs related to the change in use of real estate acquired for development. This guidance only applies to properties that are acquired with the intention to redevelop within a reasonable period of time. It would not be appropriate to apply this guidance for redevelopment of properties that were previously in use by the reporting entity as operating properties. For additional guidance related to demolition costs, see PPE 1.2.1.3.
If a reporting entity plans to demolish all or a portion of a building previously in use, the guidance on long-lived asset abandonments should be followed (see PPE 6.4.1 for further information). The property should be assessed for impairment and the remaining useful life and salvage value should be evaluated and updated if appropriate. See PPE 5 for information on impairments.
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