The Howard Hughes Company, LLC v. Commissioner: Tax Court Holds Land Developer Cannot Use Completed Contract Method

The BNA Tax and Accounting Center is the only planning resource to offer expert analysis and practice tools from the world's leading tax and accounting authorities along with the rest of the tax...

By David I. Kempler, Esq. and Elizabeth Carrott Minnigh, Esq.

Buchanan Ingersoll & Rooney PC, Washington, D.C.

In The Howard Hughes Company, LLC v. Commissioner, 142
T.C. No. 20 (2014), the Tax Court concluded that none of the
taxpayers' contracts were home construction contracts under
§460(e), and, thus, the taxpayers were not permitted to use the
completed contract accounting method of accounting. However, the
Tax Court held that the taxpayers' custom lot contracts and the
bulk sale agreements were long-term contracts and, therefore, if
those contracts were entered into in a tax year before their
completion, the taxpayers could use the percentage-of-completion
method of accounting.  In this decision, the Tax Court drew a
"bright line" that "[a] taxpayer's contract can qualify as a home
construction contract only if the taxpayer builds, constructs,
reconstructs, rehabilitates, or installs integral components to
dwelling units or real property improvements directly related to
and located on the site of such dwelling units."

Taxpayers were related entities engaged in the residential land
development business and developed land in Nevada.  Taxpayers
sold land to builders and individuals for use in constructing
residential dwelling units. The land sales were conducted in four
different formats: (i) bulk sales, (ii) pad sales, (iii) finished
lots sales and (iv) custom lot sales. In the bulk sale
transactions, Taxpayers developed raw land into villages and sold
an entire village to a builder. In the pad sale transactions,
Taxpayers divided villages into parcels and constructed all of the
infrastructure in the village, then sold the parcels to builders.
In the finished lot sale transactions, Taxpayers divided villages
into parcels, constructed all of the infrastructure in the village
and divided the parcels into lots, then sold whole parcels of
finished lots to builders. In the custom lot sale transactions,
Taxpayers divided villages into parcels, constructed all of the
infrastructure in the village and divided the parcels into lots,
then sold individual lots to individual purchasers or custom home
builders, who then constructed individual homes. In all instances,
Taxpayers did not construct residential dwelling units on the land
they sold.

For the 2007 and 2008 tax years, Taxpayers reported income from
the land sales under the completed contract accounting method. On
audit, the IRS challenged Taxpayers' accounting practices, on the
ground that the contracts for the sale of the land were not home
construction contracts within the meaning of §460(e). Additionally,
the IRS asserted that the custom lot contracts and the bulk sale
agreements were not long-term contracts and were not eligible for
the percentage-of-completion accounting method under §460.
Conversely, Taxpayers contended that the contracts were
construction contracts that imposed legal obligations upon them and
not merely sales of land. Moreover, Taxpayers contended that the
contracts were complete, for the purposes of §460, when they
incurred at least 95% of the total allocable contract costs
attributable to the contract's subject matter.

Under §460, taxpayers who receive income from long-term
contracts generally must account for that income through the
percentage of completion method. Under §460(b), this percentage of
completion method essentially requires a taxpayer to recognize
income and expenses throughout the duration of a contract. Section
460(f)(1) defines the term "long-term contract" as "any contract
for the manufacture, building, installation, or construction of
property if such contact is not completed within the taxable year
in which such contract is entered into." Pursuant to Reg.
§1.460-1(c)(3), a contract is treated as completed when it first
meets one of two tests: (i) the contract's subject matter (without
regards to secondary items) is used by the customer for its
intended purpose and at least 95% of the total allocable contract
costs have been incurred by the taxpayer or (ii) completion and
acceptance of the subject matter of the contract, "without regard
to whether one or more secondary items have been used or finally
completed and accepted."

However, under §460(e), the completed contract method may be
used instead for home construction contracts and certain other real
property construction contracts. Under the completed contract
method as set forth in Reg. §1.460-4(d), a taxpayer does not report
income until a contract is complete, even though payments may be
received in tax years before completion. Under §460(e), the term
"home construction contract" is defined as any construction
contract if 80% or more of the estimated total contract costs are
reasonably expected to be attributable to (i) the building,
construction, reconstruction or rehabilitation of dwelling units in
buildings that contain four or fewer dwelling units and (ii)
improvements to real property directly related to those dwelling
units. Pursuant to Reg. §1.460-3(b)(2)(iii), in determining the
80%, a taxpayer "includes in the cost of the dwelling units their
allocable share of the cost that the taxpayer reasonably expects to
incur for any common improvements (e.g., sewers, roads, clubhouses)
that benefit the dwelling units and that the taxpayer is
contractually obligated, or required by law, to construct within
the tract or tracts of land that contain the dwelling units."

First, the Tax Court reviewed the custom lot contracts. The Tax
Court concluded that, if the subject matter of the custom lot
contracts was solely for the sale of the piece of land, then
Taxpayers' custom lot contracts would be complete upon close of
escrow and, thus, would not be long-term contracts. The Tax Court,
however, noted that, while the custom lot contracts provided for
the sale of a piece of land, they also, as permitted by Nevada
contact law,1 incorporated by
reference to numerous other documents, including covenants,
conditions and restrictions, development plans and subdivision
maps. Upon review of the custom lot contracts together with the
documents referenced therein, the Tax Court concluded that the
subject matter of the contracts encompassed more than just the sale
of the lot. The Tax Court stated that at the time of trial,
Taxpayers still had to complete a water service line, traffic
signals, landscaping, and construction of a park. Therefore, the
Tax Court concluded that the final completion and acceptance did
not necessarily occur at the close of escrow, but rather would
occur when final completion and acceptance of the subject matter of
the contracts, which includes improvements whose costs were
allocable to the custom lot contracts, occurred. Moreover, the Tax
Court noted that custom lot transactions were not substantially
different from the finished lot transactions, which the IRS did not
challenge. Accordingly, the Tax Court held that Taxpayers were
entitled to account for the gain or loss from these contracts on
the appropriate long-term method of accounting under §460 to the
extent the contracts were not completed within the same taxable
year in which they were entered into.

The Tax Court then turned to the bulk sale agreements.  The
Tax Court concluded that the bulk sale contracts were not
substantially different from the pad sale building development
agreements (BDAs), which the parties had stipulated were
construction contracts. The Tax Court reasoned that the bulk sale
agreements were merely pad sale BDAs on a larger scale under which
the Taxpayers were obligated to build the same types of common
improvements that benefited the property sold. Accordingly, the Tax
Court held that these contracts too were construction contracts
that may be accounted for under §460 as long-term contracts to the
extent the contracts were not completed within the same taxable
year in which they were entered into.

The Tax Court then turned to the question of whether the
contracts were home construction contracts, and, therefore,
eligible for the exception to the percentage of completion method
of accounting available to home construction contracts set forth in
§460(e).  The Tax Court noted that Taxpayers did not build
dwelling units on the land they sold. Moreover, the Tax Court
concluded that Taxpayers had failed to establish that at the time
of each sale that qualifying dwelling units would ever be built on
the sold land. Under §460(e)(6), a construction contract is only
treated as home construction contract if 80% or more of the
estimated total contract costs are attributable to construction
activity with respect to (i) dwelling units and (ii) improvements
to real property directly related to those dwelling units. 
Taxpayers claimed their costs benefited dwelling units and real
property improvements related to and located on the site of such
dwelling units and, therefore, were attributable to the dwelling
units and that these costs should count towards meeting the 80%
test. The Tax Court, however, concluded that Taxpayers'
interpretation of the statute would make any construction cost
tangentially related to a dwelling unit or real property
improvement related to and located on the site of the dwelling unit
a cost to be counted in determining whether a contract is a home
construction contract. The Tax Court concluded that, under Reg.
§1.460-3(b)(2)(i), costs of improvements to real property are only
attributable to the extent they were caused or brought about by, or
occurring in consequence of, or on account of, the dwelling
units.

The Tax Court noted that arguably the costs Taxpayers incurred
were common improvement costs, which under Reg. §1.460-3(b)(2)(iii)
taxpayers may include the allocable share of these common
improvement costs in the cost of the dwelling units. However, the
Tax Court concluded that Reg. §1.460-3(b)(2)(iii) does not permit a
taxpayer with no direct construction costs with respect to dwelling
units to use common improvement costs for the purposes of the 80%
test, but rather merely allows taxpayer to include the share of the
common improvement costs allocable to the dwelling unit where the
taxpayer constructs or intends to construct qualified dwelling
units.

Accordingly, the Tax Court concluded that Taxpayers had failed
to satisfy the 80% test and, thus, held that Taxpayers' contracts
and agreements did not qualify as home construction
contracts.  In reaching its conclusion, the Tax Court
distinguished the current case from Shea Homes, Inc. v.
Commissioner
, 142 T.C. No. 3 (2014), in which it had held
that, in determining whether a contract satisfied the 80% rule, the
taxpayers could include the allocable share of the cost that they
reasonably expected to incur for any common improvement. However,
the Tax Court noted that in Shea Homes the taxpayers
were developers who both developed land and built dwelling units
and under the terms of the contracts the subject matter of those
contracts included the dwelling unit, the lot on which the dwelling
unit sat and the common improvements and amenities. Accordingly,
the Tax Court stated that the starting point in Shea Homes
was that the taxpayers' contracts were for the construction of
qualifying dwelling units. The Tax Court emphasized that at no
point in Shea Homes decision did the Tax Court held that a
home construction contract could consist solely of common
improvement costs. The bright line test adopted by the Tax Court
herein removes any ambiguity regarding the application of the
Shea Homes decision.

For more information, in the Tax Management Portfolios, see
Connor, Smith, and Turgeon, 575 T.M.
, Accounting for Long-Term
Contracts,  and in Tax Practice Series, see ¶3530, Methods
of Accounting, and ¶3610, Long-Term Contracts.

  1 See Lincoln Welding Works, Inc.
v. Ramirez
, 647 P.2d 381, 383 (Nev. 1982).