Vexing Questions in the Construction Business—and in the MetaverseMarch 8, 2023
Construction companies build the world around us. They’re also impacted by the world around them. Virtually every economic trend, market condition and regulatory change directly affects builders in some form. In its 2023 forecast, the Construction Financial Management Association (CFMA) discussed material costs, infrastructure opportunities, the labor squeeze and more. Now well into 2023, we have several other hot-button topics emerging that builders need to be aware of. The last one will blow your mind.
Is an Independent Contractor an Employee?
Let’s talk about worker classification. You’ve probably heard this buzz term. If you haven’t, it’s somewhat self-explanatory, defining whether someone you hire is an employee or independent contractor. Remote work and the gig economy landed worker classification on the U.S. Department of Labor’s (DOL) radar for a refresh. The DOL is moving to reclassify certain (and likely many) subcontractors as employees based on six factors to be considered holistically. The current five criteria were established in 2021 to streamline “economic reality.” The new criteria will restore consideration of a worker’s investment in a business as a standalone core factor.
“While independent contractors have an important role in our economy, we have seen in many cases that employers misclassify their employees as independent contractors, particularly among our nation’s most vulnerable workers,” said Secretary of Labor Marty Walsh in an official press release from the DOL. “Misclassification deprives workers of their federal labor protections, including their right to be paid their full, legally earned wages. The Department of Labor remains committed to addressing the issue of misclassification.”
Of course, the difference between an employee and independent contractor is huge for a construction company in terms of tax ramifications. With independent contractors, you don’t have to pay Medicare and Social Security taxes. The proposed changes to worker classification are estimated to create $188 million in revenue per year through these taxes alone. If you haven’t already, start thinking about how your business model may need to adjust to a world where you can’t enlist independent contractors so freely.
Is a Builder an Investor?
This has always been a tightrope for developers. In some circumstances, you want to categorize deductions as ordinary losses to offset ordinary income. Yet, when a project sells, you want the opposite classification to obtain the favorable capital gain tax treatment. You generally look to reclassify the activity away from the criteria of ordinary income/loss to an investment gain/loss.
A 2022 U.S. Tax Court ruling set precedent for the difference between a real estate dealer and a real estate investor through eight factors in totality:
- The purpose for which the property was acquired.
- The purpose for which it was held.
- Improvements, and their extent, made to the property by the taxpayer.
- Frequency, number and continuity of sales.
- The extent and substantiality of the transactions.
- The nature and extent of the taxpayer’s business.
- The extent of advertising to promote sales (or lack of advertising).
- The listing of the property for sale directly or through brokers.
For any given property, if it’s determined that you’re a real estate dealer, your earnings are treated as ordinary income. If you’re an investor, the earnings are subject to capital gains tax. A real estate dealer designation can be supported when an individual can demonstrate 500 hours in performing duties related to developing, selling, building or operating real property such as apartments shopping plazas, homes, etc. This designation allows for losses to be used against other ordinary income such as W-2 income.
For example, an accountant selling a single property would likely pay capital gains tax because real estate sales aren’t the accountant’s main area of business, and the accountant likely acquired the property with the purpose of letting it appreciate and eventually turning it for a profit. The concern for a real estate developer would be in having capital gains applied to properties that you hold for a period of time. There’s still some ambiguity in the rules, allowing you to structure holdings favorably with the help of an accountant who’s knowledgeable and up to date in real estate tax planning.
Is the Metaverse Real (Estate)?
Now, things are about to get weird. In a New York Times article titled, “The Next Hot Housing Market Is Out of This World. It’s in the Metaverse,” a builder adds a virtual replica of a Miami mansion to sweeten the sales pot. Access to schools, freeways and, in Miami, world-class beaches and entertainment? Yeah, yeah, great. Just give me access to a make-believe home in the Metaverse, please.
You have to see it to believe it…and even then, you still might not understand it. Typically, when we talk about builders making technology investments for business, we’re pointing to the latest machinery, digital marketing, and maybe industrial automation if we’re feeling extra ambitious. But the Metaverse? Unreal. Nevertheless, the foundation for a virtual world has been laid and will be built upon. It’s easy to write it off, but history says that could be a mistake. Naysayers once questioned the usefulness of the internet and email. Whether the Metaverse real estate market grows or flops is yet to be seen, but it’s indeed a verifiable market as of now.
The next questions in your business could conceivably be:
- When you build a home in the Metaverse, are the workers you hire to work in the Metaverse employees or independent contractors?
- If you start to make money selling homes in the Metaverse, how will you be taxed on the profits?
Time will only tell—and when it does, Curchin’s construction accounting team will be the first to let you know.