Capitalizing Costs: Planning for a Return of Construction Activities

Recently released economic data shows that the United States economy is continuing to struggle. The most recent United States gross domestic product (GDP) figures, released in July, revealed that the GDP grew at a rate of 2.4 percent during the second quarter of 2010, a rate lower than forecasted. Economic data continues to show struggling labor and wage markets. Coupled together, these economic reports show that the United States economy is growing at a slow pace. And this less-than-rosy economic news contributes to persistent fears that the United States economy may be headed toward a double-dip recession.

The gaming industry is acutely aware of the slow economic recovery. Major United States gaming markets have been affected by the recession. A survey of United States jurisdictions readily discloses that growth in gross gaming revenue remains stagnant, if not declining. As a result, many casino operators and suppliers continue to operate cautiously. This is particularly true with respect to developing new casino properties. Beginning in 2008, several high-profile casino development projects were delayed, scaled back or altogether shelved indefinitely.

Nevertheless, despite the slow climb out of the economic meltdown of 2008 to 2009, there has been a distant shimmer of optimism. While there have been several newsworthy bankruptcies involving casino operators, and while rumors of impending bankruptcy filings continue to persist, Greektown Casino and Trump Entertainment successfully emerged from Chapter 11 bankruptcy reorganization proceedings this summer. Further, it appears that a reorganization plan is close to being confirmed in the Station Casinos bankruptcy proceedings.

Moreover, in the past 12 months, high-profile casino developments that had been delayed have now opened or are expected to open in the near future. These projects include the recent opening of portions of the highly-anticipated MGM MIRAGE City Center project and the Wynn Encore tower, both on the Las Vegas Strip. The Cosmopolitan of Las Vegas is expected to open later this year. Further, there have been recent encouraging developments that indicate the Revel Casino project in Atlantic City will be restarted.

Interest rates remain at historically low levels. While casino operators may not yet be willing (or able) to proceed with developing long-shelved casino-hotel development projects, now may be an opportune time to revisit these projects no operators have been able to reduce significant debt levels that plagued the industry during the 2008 economic meltdown. Therefore, a little-publicized Internal Revenue Service General Counsel Advice (GCA) issued on March 27, 2009, offers guidance with respect to capitalizing indirect costs during the construction of a casino-hotel project. The IRS guidance, GCA 200913011 (March 27, 2009), raises tax planning considerations when structuring a casino-hotel project.

The IRS Advice
A hallmark of United States federal income tax law is that businesses are allowed to recover the costs of many expenses by reducing gross income. There are three general permissible cost recovery approaches under the federal tax law. First, the most taxpayer-friendly cost recovery rule (assuming the business has some income) allows for expenses to be currently deducted against income. Second, the costs for goods that have a useful economic life lasting more than one year may be eligible for depreciation or amortization deductions. Depreciation or amortization deductions permit a business to recover the cost of goods over a period of years through annual deductions of a portion of the cost of the good. Finally, the most taxpayer-unfriendly cost recovery rule—at least from a timing perspective—requires expenses to be included in the “basis” of the property and are then recovered upon subsequent disposition of the property. That is, in this latter category, the initial cost is recovered by not incurring tax (e.g., the amount is not included in taxable gain) on that amount when the asset is sold in the future.

The federal tax law requires certain costs incurred in the construction of property to be capitalized into the cost of the constructed property. The “cost” of capitalizing expenses is the potential shift in the timing of when cost recovery will be allowed. That is, the capitalization rules can operate to shift the timing of otherwise currently deductible expenses by requiring the expenses to be capitalized into the basis of the property produced. This means that cost recovery of an expense may—and likely will—be delayed. For example, interest payments are ordinarily currently deductible expenses. However, if the interest payment is an indirect cost associated with the construction of property, the taxpayer may be required to capitalize the interest payments within the cost of the property produced. Correspondingly, the business would recover the costs of the interest payment through depreciation deductions or upon a subsequent sale of the property.

The capitalization rules generally provide that a business must capitalize the costs of real or personal property produced by the business. The capitalization rules also require the “proper share” of the “indirect costs” of property produced by a business to be capitalized. Notably, by statute, interest expenses paid during the “production period” for certain property must be capitalized. The production period is defined by the federal tax law to mean the period beginning on the date production begins and ending on the date that property is ready to be placed in service or is held for sale.

From a taxpayer’s perspective, a business prefers to be in a position to complete the construction of a project, or a separate unit of the property, as quickly as possible in order to end capitalizing interest costs and begin cost recovery. Undoubtedly, tension can arise, particularly with regard to whether a project consists of separate units of property. The capitalization rules are also well-known for being a gray area of the tax law and, thus, are ripe for disagreement.

Unique issues can arise in connection with real estate development projects such as a casino-hotel. For example, regulations promulgated by the IRS recognize that condominium units can be treated as separate units of real property. Thus, as each condominium unit is completed, a taxpayer is no longer required to capitalize the indirect costs, including interest expenses, attributable to the completed units. Similarly, examples in the Treasury regulations arrive at a similar conclusion with respect to the development of a shopping mall by treating each leased space as a separate unit of real property. Hence, developers are often faced with the issue of whether any portion of a development project can be treated as a separate unit of the project as a whole and, therefore, allow the developer to begin recovering its costs as each portion is constructed.

GCA 200913001 is highly relevant for casinos developing new casino-hotel projects. The GCA directly addressed the capitalization of interest expenses incurred in developing a casino-hotel project. The GCA neither identifies the particular casino project nor the state where the project was developed, but as discussed below, the state gaming law became a central fact that supported the conclusion arrived at by the IRS.

The facts relating to the particular casino-hotel project at issue in GCA 200913001 are partially redacted. The facts do, however, disclose that the casino was part of a complex that included a hotel tower, a gaming floor, a parking garage, restaurants and other amenities such as a spa, meeting rooms and an indoor pool. Under the gaming law of the undisclosed state, the gaming commission must issue a certificate of operations prior to the casino commencing operations.1 The facts are not entirely clear regarding whether the certificate of operations, under state gaming law, was required to be issued in order to operate the hotel, restaurants and related amenities.2 Prior to issuing the certificate of operations, the complex was open for limited hours during a test period. At the conclusion of the test period, the certificate of operations would be issued.

The casino operator, relying on examples in the Treasury regulations, took the position that each hotel room, along with the casino, were separate units of property. The casino developer attempted to analogize its project to examples contained in the Treasury regulations that stated that condominium units and space in a shopping center that was to be separately leased constituted separate units of real property for purposes of the capitalization rules. The effect of the casino’s position was to allow the casino to end capitalizing, presumably saving significant interest expenses, and begin to depreciate the costs of the completed portions of the hotel and casino. When the considerable expenses of developing a casino-hotel project are taken into account, it becomes abundantly apparent that the casino operator had the potential for large tax savings by being able to commence recovering interest expenses as portions of the casino-hotel project were completed.

The IRS in GCA 200913001, however, concluded that neither the individual hotel rooms nor the casino were separate units of property for purposes of the capitalization rules. Moreover, the GCA concluded that the hotel and casino were functionally interdependent. Under Treasury regulations, property that is considered to be functionally interdependent is treated as a single unit of property. As a result, under GCA 200913001, the casino was required to continue to capitalize its interest expenses for the entire development of the project, until the operations certificate was issued. At this point in the legal analysis, state gaming law played a pivotal role.3 The IRS apparently construed the entire casino-hotel project as directed at producing an operating casino. According to the IRS, “[n]one of the facts indicate that the hotel was intended to operate for the production of income without the casino having also been approved for operating.” Therefore, based on state gaming law and the facts presented, the hotel and casino were viewed as one unit of property.

What Does This Reveal?
Casino operators planning the development of a casino-hotel project can learn several lessons from GCA 200913001. As a starting point, GCA 200913001 suggests that developers should thoroughly examine state gaming laws. For instance, it would be important to ascertain whether state gaming law includes a “hotel” as part of the definition of a casino. Additionally, it should be determined whether a hotel that contemplates a casino can be operated without obtaining a gaming license. New Jersey gaming law, for example, provides that a casino license cannot be issued unless the casino is located in an approved hotel.

The developer may also need to carefully structure the components of the project. For example, in GCA 200913001, the IRS suggested that the hotel would not have been built without the casino. Thus, the IRS could readily reach the conclusion that the casino and hotel were functionally interdependent. This line of analysis raises the question whether any facts exist to support a position that the hotel and casino serve separate, but perhaps complementary, functions. An example set forth in the underlying Treasury regulations explains that a grocery store constructed in conjunction with a condominium development is a separate unit of property where the grocery store is held for the production of income separately from the condominium development and is not a common feature of condominium development. Thus, casino developers may be able to draw analogies to the Treasury regulations examples during the course of planning a casino-hotel development.

GCA 200913001 reiterates that the capitalization rules relating to the production of property represent the quintessential gray area of the tax law. Not only can state gaming law impact the federal tax law analysis, but the particular facts and circumstances of the casino development will also impact the analysis. As casino operators begin to revisit delayed development projects, or contemplate new projects, it is appropriate to contemplate the interaction of the capitalization rules and plan accordingly.

Author’s Note: In response to IRS Circular 230 requirements, any discussions of federal tax issues in this article are not intended to be used and may not be used by any person for the avoidance of any penalties under the Internal Revenue Code, or to promote, market or recommend any transaction or subject addressed herein.

Footnotes
1 While the governing state gaming law was not disclosed, the description of the gaming law is strikingly similar to New Jersey’s gaming law.
2 Whether state gaming law requires the issuance of a certificate in order to operate the hotel and related amenities could be an important fact. Specifically, if a certificate is required, the IRS would have an additional argument that the casino and the hotel are “functionally interdependent.” Under Treasury regulations, units of property are treated as one unit when the portions are functionally interdependent.
3 As an example, New Jersey gaming law provides that a casino license shall not be issued unless the casino is located within an approved hotel. See N.J. Stat. Ann. § 19:43-6.2(a). New Jersey gaming law also requires the issuance of an operations certificate prior to opening the casino. The intricacies of state gaming law can, therefore, impact the federal tax law analysis.

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