When most people think of the research and development (R&D) tax credit, they think of manufacturing. However, other industries can also benefit from this credit. In my August 5th post, we discussed the basics of the R&D credit and how it applies to manufacturers. Now let's focus on how the credit can qualify in the real estate industry.
Because architecture and engineering sciences are used in the real estate industry, we can easily meet our "technological in nature" test. To qualify for R&D however, we still must meet the other tests. As a refresher, the four tests are:
Technological in Nature
Elimination of Uncertainty
Process of Experimentation
Below are some examples of activities that are performed in the real estate industry that could qualify as R&D.
Testing alternative materials
Designing a unique structure
Designing a "green" building
Developing a structural and foundation system to meet site-specific conditions
Engineering design to improve a building's function or heat, light and power efficiency
Developing HVAC, electrical, sanitary or water waste systems
Once it's determined that you've engaged in a qualified activity, it is important to determine who funded the activity. Identifying who funded the activity, and ultimately who bore the risk, can be tricky in real estate. Clients engage developers who hire architects and engineers to perform the research. With several different individuals involved in the qualified activity, who is entitled to the credit? The answer generally can be found upon a close review of your price contracts.
To help clarify, let's take a look at how testing alternative materials can meet our tests for qualified R&D and who is entitled to the credit.
Company R is a real estate development company who develops commercial real estate properties. Company R hires Company E, an engineering company, to test out a new, cheaper building material that has come on the market. Company R wants to verify that this new material will meet the necessary specifications and will perform as well, if not better, than the old material. Is this qualified R&D?
Technological in Nature Test: YES. They are using engineering sciences.
Elimination of Uncertainty Test. YES. The product is new and Company R is uncertain that it will function appropriately. The material needs tested and verified before they begin to use it in their building.
Process of Experimentation Test. YES. Company R hires Company E to run tests on the materials to determine that it will meet certain specifications.
Permitted Purpose Test. YES. Cost reduction is a permitted purpose.
The activity has met the tests and is qualified R&D. Now, let's discuss how the credit is funded.
Assume that Company R and Company E have a fixed-price agreement. This agreement states that Company E must have final results to Company R by a specific date or they will not be paid. Because Company R was only liable for payment if Company E met this deadline, Company E holds the risk. Even if Company E meets the deadline and receives payment, they are still entitled to the R&D credit.
Now assume, the two companies have a cost-plus agreement. Under this agreement, Company R must reimburse Company E for predefined tasks at predefined rates. These payments were required even if Company E did not complete the project successfully. Because of this, Company R holds the risk and is entitled to the R&D credit. Company R will pick up 65% these costs as contract engineering expenses as part of the credit calculation.
There are many nuances in applying the R&D credit to any industry, including real estate. But more often than not it is a credit well worth looking into. And if you think you missed the R&D credit on a prior return, there may still be an opportunity to claim it. Read "New Opportunity for Missed R&D Credit."