Successful tax planning involves not only minimizing the amount of income but also managing the timing of a taxpayer’s income and deductions. Many disputes with the IRS involve deferral of income, and the IRS has taken a particularly hard line on how taxpayers report income from real estate construction contracts.
Now, in a significant win for real estate developers, the U.S. Tax Court has ruled that residential land developers can defer income from construction projects until the common areas and amenities are finished. (Shea Homes Inc., v. Commissioner, 142 T.C. No. 3 (2014)) The dispute was over a practice called the “completed contract method” of accounting for long-term contracts. Under this method, taxpayers report no income until a contract is complete and acceptance has occurred. Only home construction contractors and small construction contractors can use this method. (Small construction contractors are those whose average gross receipts do not exceed $10 million over a three-year period.) The method applies to long-term contracts, those not completed within the tax year they were entered into.
Facts of the Case
Shea Homes and its related entities, made up of family partnerships and corporations, developed large, planned residential communities. They used the completed contract method of accounting and waited to report income until all aspects of the projects were finished. The IRS challenged this reporting, saying Shea Homes had to report income on the home sales as they closed.
The key issue in the case involved whether the home sales were long-term contracts and, if so, what was the appropriate date of completion of the contracts. Under IRS rules, a contract is complete when either:
a) the contract’s “subject matter” is used by the customer for its intended purpose and the developer incurs at least 95% of the contract costs; or
b) there is final completion and acceptance by the buyers.
The IRS argued that the subject matter of the sales contracts was only the houses and lots and did not include the common improvements and amenities. Thus, Shea Homes should have reported income as the developer closed on the houses, according to the IRS. Shea Homes, on the other hand, took the position that the contracts were not complete until the project was complete and all amenities were finished, the last road was paved, and the municipality released the final performance bond.
Tax Court Allows Deferral
The Tax Court agreed with the taxpayer and allowed deferral of income until the common areas and amenities were finished. The Court observed that the amenities were an “essential element” of the home purchase contracts and were crucial to the taxpayer’s sales efforts. Thus, the Court found, the subject matter of the contracts consisted of the home and the larger development, including amenities and other common improvements.
Observations: The IRS has long been concerned that real estate developers have been using the completed contract method to improperly defer income. It has taken an uncompromising approach in audit and in litigation, ultimately resulting in this set of consolidated cases in the Tax Court. The Agency’s loss in the Shea Homes case reflects the Court’s belief that Congress specifically intended that home builders should get generous deferral of income. The Court noted that land developers spend a lot on the early construction phase of their developments for things like grading the land, installing utilities, and building roads. The total cost of projects is not easy to predict, and it is common that a developer’s profits cannot accurately be determined until the development is nearly complete. The good news for the housing market is that developers responsible for the uptick in large master planned community projects may safely use longer deferral periods with fewer challenges by the IRS.