Planned Development Home Builders May Be Able to Defer Income Until Completion of Common Improvements

There is a degree of more certainty in the use of the completed contract method (CCM) of accounting for long-term contracts for planned community home builders after the Ninth Circuit affirmed  the Tax Court’s holdings August 24, 2016  in Shea Homes, Inc. v. Commissioner, 142 T.C. 60 (2014), aff’d, No. 14-72161, 2016 BL 274845 (9th Cir 2016).

The Internal Revenue Code generally requires that a taxpayer report income in the taxable year in which it is received, under §451(a), but also provides a special set of accounting rules under §460 for taxpayers performing long-term contracts under §460(e)(1)(A) of the Code and Reg. §1.460-1 - §1.460-6. 

A long-term contract is one for the construction, installation, building, or manufacturing of property that begins in one year and is completed in a later contract year.  While generally, long-term contracts must be accounted for using the percentage of completion method (PCM) of accounting, there are exceptions, which allow use of other methods, such as the percentage of completion capitalized cost method (PCCM) or the completed contract method (CCM).  

A construction contract that is a long-term contract, that is, it spans more than one taxable year, and is for the construction of homes, and the subject matter of the contract has not been completed at the time the contract is entered into, is not required to use the PCM under Reg. § 1.460-1 (b)(2)(i), and is permitted to use the CCM.    

Under §460, a home construction contract includes any construction contract if 80% of the total estimated contract costs, as of the close of the taxable year the contract is entered into, are reasonably expected to be attributable to the construction of improvements to real property directly related to qualifying dwelling units and located on the site of such dwelling units under §460(e)(6)(A  and Reg. § 1.460-3 (b)(2)(iii).    

In Shea, taxpayers (T) were builders and developers of planned communities ranging in size from 100 homes to more than 1,000 homes in Colorado, California and Arizona.  In marketing homes to potential buyers, T emphasized the features and lifestyle of the communities in its advertisements.  T’s business involved the analysis and acquisition of land for development, the construction and marketing of homes and the design and construction of developments and homes on the land they acquired.  Costs incurred included acquisition of land, financing, municipal and other regulatory approvals of entitlement, construction of infrastructure, construction of amenities, construction of homes, marketing, bonding, site supervision and overhead and taxes.  The primary source of revenue was from the sale of houses.   

The Ninth Circuit affirmed the Tax Court decision that allowed Shea Homes, Inc. to use the CCM when they met the  95%  test under Reg. §1.460-1(c)(3)(i)(A) and incurred 95% of the costs of the development, not when home purchases closed in escrow.  The court held that final completion and acceptance under Reg. §1.460-1(c)(3)(B) does not occur until final completion and acceptance of the subject matter of the contract which included completion of the common improvements.  

For each tax year, T calculated on a development-by-development basis, whether it had incurred at least 95% of the budgeted costs of the development, including the costs of the houses and the common improvements and amenities.  If the incurred costs were equal to or greater than 95% of the budgeted costs, T reported income for that tax years for homes that had closed in escrow up to that date, and if not, the income was deferred.  The IRS had contended that the subject matter of the contracts consisted only of the houses and lots upon which the homes were built and the contract for each home met the final completion and acceptance test upon the close of escrow for the sale of each home.  The court agreed with the Tax Court’s holding that T was selling not just a house and a lot, but also the homeowner’s interest in and right to use the various upscale amenities included in the developments.  

The T in Shea Homes performed home construction, development and construction of common improvements, and secured all government approvals in the states the communities were located.  The court found that as a matter of fact, and state contract law, both the homes and the development lifestyle were the subject matter of the contracts, and use of the CCM properly reflected taxpayer income for the years at issue.  As a caution to taxpayers who may believe that large developments may qualify for long or almost unlimited deferral periods, the court reiterated the Tax Court’s statement “that a determination of the subject matter of the contract is based on all the facts and circumstances.”

The LMSB (now LB&I) Division of the IRS has addressed the use of the CCM in the residential construction industry.  LMSB-04-0209-006 was issued after promulgation of proposed regulations in 2008 (Reg. 120844-07, 73 Fed. Reg. 45,180 (Aug. 04, 2008)) that would expand the types of contracts eligible for the home contract exemption.   The proposed rules would provide that a contract for the construction of common improvements only does qualify as a home construction contract.  The proposed regulations, however, are not effective until the rules are published in the Federal Register as final regulations and cannot be relied upon until that time.  The IRS guidance to its industry directors addressed what the IRS viewed as a misuse of the CCM by the developers of large residential communities, since such communities may take years to complete, and misuse of the method could result in improper deferral of income from land sales, home sales and subcontract work.  

It is currently the IRS position that a contract solely for the construction of common improvements cannot be a home construction contract.  See LMSB-04-0209-006, Attachment 2.  The preamble to the proposed regulations (Reg. 120844-07, 73 Fed. Reg. 45,180 (Aug. 04, 2008)) provides that the IRS and Treasury expect to issue specific severing and completion rules for home construction contracts accounted for using the completed contract method, which to date, has not occurred, though Regulations under §460 regarding home construction contracts and rules for certain changes in method of accounting for long-term contracts are currently on the 2016-2017 Guidance Priorities list.