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Tax Court Upholds Real Estate Development Co. Application of Completed Contract Method of Accounting to Home Construction Contracts

Published: April 16th, 2014

By: Stephen R. Looney

     In Shea Homes, Inc., et al. v. Comm’r, 142 TC 3 (2014), the Tax Court held that the taxpayers (three related real estate development companies) correctly applied the completed contract method of accounting to their home construction contracts by their interpretation of the “subject matter of the contract” as not only including the houses, the lots and improvements to the lots, but also the common improvements/amenities related to the overall development or phase of a larger development.

     Shea Homes, Inc., Shea Homes, LP and Vistancia, LLC (the “taxpayers”) are related companies that build and develop large, planned residential communities. They develop the land and construct homes and common improvements, including substantial amenities. For the years at issue, they reported income from their contracts for the sale of homes using the completed contract method of accounting. Under the taxpayers’ interpretation of the completed contract method of accounting, their contracts are complete when they meet the use and 95% test prescribed under Reg. 1.460-1(c)(3)(A), and incur 95% of the costs of the overall development. On the other hand, under the IRS’s interpretation of the completed contract method of accounting, the subject matter of the contracts of the taxpayers consisted only of the houses and the lots upon which the houses are built, and did not include the common improvements/amenities of the overall development. Under the IRS’s interpretation, the contract for each home meets the final completion and acceptance test upon the close of escrow for the sale of each home and contracts entered into and closed within the same tax year are not long-term contracts eligible for the completed contract method of accounting under Section 460.

     Section 460 generally provides that taxpayers who receive income from long-term contracts must account for that income through the percentage of completion method. Under the percentage of completion method, a taxpayer recognizes income and expenses throughout the duration of a contract. However, under Section 460(e)(1)(A), a taxpayer may report income from home construction contracts under the completed contract method of accounting.

     Section 460(f)(1) defines a long-term contract as “any contract for the manufacture, building, installation, or construction of property if such contract is not completed within the tax year in which such contract is entered into.” The statute does not define completion, but the regulations provide that a contract is completed when it first meets one of two tests: (1) the use and 95% completion test; and (2) the final completion and acceptance test. Under the first test, a contract is completed upon “use of the subject matter of the contract by the customer for its intended purpose (other than for testing) and at least 95% of the total allocable contract costs attributable to the subject matter have been incurred by the taxpayer.” Under the second test, the contract is completed upon “final completion and acceptance of the subject matter of the contract.” With respect to the second test, in determining whether final completion and acceptance of the subject matter of the contract have occurred, the taxpayer must consider “all relevant facts and circumstances.”

     The regulations also provide that taxpayers are to apply the test to determine when a contract is completed under the completed contract method without regard to whether one or more “secondary items” have been used or finally completed and accepted. Consequently, in applying the 95% completion test, taxpayers must separate the portion of the gross contract price and the allocable contract costs attributable to the incomplete secondary item(s) from the completed contract.

     A taxpayer may account for income from home construction contracts under the completed contract method because Section 460(e) provides that the percentage of completion method will not apply to any home construction contract. A home construction contract is any construction contract if 80% of the estimated total contract costs (as of the close of the tax year in which the contract was entered into) are reasonably expected to be attributable to building, construction, reconstruction, or rehabilitation of, or the installation of any integral component to, or improvements of, real property with respect to – (i) dwelling units containing four or fewer dwelling units (ii) improvements to real property directly related to such dwelling units and located on the site of such dwelling units.

     Because a significant portion of the contract costs may be attributable to items not “located on the site of such dwelling units,” such as development infrastructure, taxpayers can have trouble meeting the 80% requirement of Section 460(e)(6)(A). However, the regulations provide that taxpayers may include in the cost of the dwelling units their allocable share of the costs that the taxpayer reasonably expects to incur for any common improvements (such as 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. Consequently, for purposes of determining whether a contract qualifies as a home construction contract under Section 460(e), it is clear that the taxpayer includes, for the 80% test, costs attributable to common improvements/amenities in the manner dictated by the regulations.

     The IRS argued that the taxpayers should report income from their long-term contracts for the years in which the contracts closed in escrow because the subject matter of the contracts was only the home and the lot upon which the home sits (and not the common improvements of the development as a whole). Consequently, according to the IRS, each contract is completed in the year in which the escrow closes and the year that final completion and acceptance occurs.

     On the other hand, the taxpayers argued that the subject matter of the contracts is broader and encompasses the entire development or, with respect to some large developments, the development phase of which the home is a part. In support of their position, the taxpayers contended that a contract comprises all documents provided to the buyer, any documents expressly referenced therein or incorporated therein by law, and easements, restrictions and other documents recorded as encumbrances on a home purchase title. Thus, final completion and acceptance does not occur until, as to the phase or the development, the final road is paved and the final bond is released. Under the taxpayers’ interpretation of the completed contract method, the use and 95% completion test is met when the taxpayers incur 95% of the costs attributable to the development phase or the overall development. The taxpayers also contended that because the 80% test for a home construction contract includes the allocable share of the costs of common improvements/amenities, the 95% test must also include such costs.

     The IRS argued alternatively that if the court held that the subject matter of the contracts is broader than the house and the lot, the 95% completion test should be applied without regard to the costs attributable to common improvements because such common improvements constitute “secondary items.” The taxpayers, however, contended that the common improvements are part of the primary subject matter of the contract, not secondary items, and that they may include such allocable costs in applying the 95% test.

     After undergoing an exhaustive review of the taxpayers’ contracts, including the integration clauses contained in the contracts, as well as the applicable state laws governing real property sales, the Tax Court concluded that the IRS’s interpretation of the contracts and the relevant state legal definitions of real estate were too narrow. Specifically, the Tax Court stated that “… state laws do not necessarily restrict the subject matter of the real estate contract to just a house and the lot upon which it sits.” The Tax Court also stated that the IRS’s analysis was “simplistic and shortsighted,” and did not acknowledge the “complex relationships created by the purchase and sales agreement, … that continue long after the first home is built.”

     Consequently, the Tax Court concluded that the subject matter of the contract within the meaning of Section 460 includes the house, the lot, and improvements to the lot, as well as the common improvements in the development. Thus, for purpose of the 95% completion test, the taxpayers correctly tested the total allocable costs associated with the development against the costs incurred to date. Additionally, the Tax Court concluded that for purposes of the final completion and acceptance test, the taxpayers appropriately determined that, on the basis of the facts and circumstances, final completion did not occur until the final bonds are released and the final roads paved.

     Additionally, the court agreed with the taxpayers that the common improvements were not secondary items but that the primary subject matter of the contracts included the house, the lot, improvements to the lot, and common improvements to the development as a whole. The court found as a factual matter the amenities to be of great importance to, and a crucial aspect of, the taxpayers sales effort, obtaining governmental approval of the development, and the buyer’s purchase decision, and thus the amenities were an essential element of the home purchase and sale contract.

     Finally, the Tax Court concluded that the IRS could not change the taxpayers’ method of accounting even if the IRS’s proposed method more clearly reflected income. The Shea case represents a major victory for taxpayers engaged in the home construction business.