When we develop the extension we do not unzip the extension over Magento like a normal install. We keep the paths separate & use symlinks. This way our version control system [git] does not try to track Magento's files.

cd /home/josh/www
git clone git@github.com:vehiclefits/Vehicle-Fits-Magento.git
cd /home/josh/www/magento/app/code/local
ln -s /home/josh/www/Vehiclefits-Magento/app/code/local/Elite Elite
cd /home/josh/www/magento/lib
ln -s /home/josh/www/Vehicle-Fits-Magento/lib/VF VF
This assumes you have Magento installed at /home/josh/www/magento/. We check out the Vehicle Fits repository in /home/josh/www/, in app/code/local we create a symlink for the Elite folder to point to where we just checked out the repository to. We also do the same for the lib/VF folder.