A Review of Inventory Accounting for Construction Companies

When Inventory Becomes Part of the Business

Many construction businesses — and increasingly, real estate development firms — reach a point in their growth when they decide to maintain inventories. They might keep on hand items such as building materials, supplies, personal protective equipment, and tools. Maybe yours already does.

A company’s tax accounting method for inventory can significantly affect its tax bill — especially when costs are trending upward. Whether your business has an inventory now or is considering building one, let’s review some of the major concepts involved.

The Tax Impact of Inventory

Inventory items generally aren’t taxed until they’re sold. However, inventory affects your taxes before then because of its role in determining your company’s taxable income. Specifically, inventory is one of the components in calculating “cost of goods sold” (COGS), which for contractors includes direct costs associated with the performance and completion of projects.

COGS typically represents a substantial portion of most construction and real estate companies’ tax-deductible expenses. Generally, the lower your COGS, the more income you’ll report to the IRS — and the more taxes you’ll pay. On the other hand, higher COGS usually results in lower taxable income and reduced tax liability.

FIFO vs. LIFO

For all types of businesses, including construction and real estate development companies, the two most common tax accounting methods for inventory are first-in, first-out (FIFO) and last-in, first-out (LIFO).

True to its name, FIFO assumes that your business uses inventory in the order items are purchased. Most contractors and developers tend to operate this way — using older materials first to reduce the risk of expiration, damage, or obsolescence.

Under FIFO, the unused items remaining in your ending inventory are typically those most recently purchased — reported as assets on your balance sheet. In an inflationary market, these items will be more expensive. At the same time, inventory charged to COGS is typically cheaper, leading to a lower COGS, higher taxable income, and increased tax liability.

LIFO, on the other hand, assumes you use your newest inventory first. That means older, less expensive items remain in your ending inventory. In a rising-cost environment, LIFO increases COGS by allocating newer, pricier items to expenses — reducing taxable income and possibly easing the transition into a higher tax bracket.

However, if inventory costs fall — which has been rare in recent years — LIFO could result in higher taxable income by charging lower costs to COGS.

More Than Just Taxes

Although LIFO may offer a tax benefit in a high-cost environment, FIFO has other advantages worth noting:

• Ease of implementation. FIFO is simpler to start and manage. You don’t need a formal IRS election — just report it on your first tax return. LIFO, however, requires you to file IRS Form 970 and obtain IRS permission to revoke it later.

• Financial reporting strength. FIFO typically results in a stronger balance sheet. Since your ending inventory reflects the most recent (and highest) costs, your asset valuation appears more favorable — which can be appealing to lenders or investors reviewing your financials, especially in real estate development.

• Operational alignment. FIFO often mirrors the actual use of inventory on construction sites and property builds. That means your financial statements will more accurately reflect your materials usage and current inventory value.

LIFO, in contrast, can distort your financial position by lowering inventory value — sometimes based on items no longer even in your possession.

A Critical Accounting Decision

Choosing a tax accounting method for inventory is a strategic decision. For example, how it impacts your financial statements could affect your ability to secure external financing, particularly for large construction jobs or real estate development projects.

Whether you’re just beginning to manage inventory or you’ve had one in place for years, we can help you determine the best approach based on your business’s goals, growth stage, and the current economic climate.

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