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Home Builder Triumphs over IRS; Tax Court Allows Deferral of Millions.
(Parker Tax Publishing February 27, 2014)

A recent Tax Court decision is good news for home builders and real estate developers who seek to defer profits on a long-term contract. Such taxpayers often battle with the IRS over the amount of profits includible in income in any given year. For taxpayers using the percentage of completion accounting method, the battle often centers on the percentage of the contract completed. For taxpayers using the completed contract method of accounting, the battle often centers on whether the builder or developer meets the requirements for using that method and when the contract is considered completed. In Shea Homes, Inc. and Subs. v. Comm'r, 142 T.C. No. 3 (2014), a case involving one of the largest private homebuilders in the United States, the taxpayer successfully argued that it could defer profits under the completed contract method on home sales in a planned community until 95 percent of that community, including common improvements and amenities, was completed and accepted. As a result, the taxpayer was able to defer taxes on millions in profits.


Shea Homes, Inc. and Subsidiaries (SHI), is an affiliated group of corporations with SHI being the common parent. Shea Homes Limited Partnership (SHLP) is a limited partnership and J F Shea, LLC (JFLP), is the tax matters partner of SHLP. Other related businesses include Vistancia, LLC (Vistancia), a limited liability company, and Shea Homes Southwest, Inc. (SHSI), the tax matters partner of Vistancia.

SHI, SHLP, and Vistancia are builders/developers of planned communities, ranging in size from 100 homes to more than 1,000 homes in Colorado, California, and Arizona. During 2004 and 2005, they sold homes in 114 developments. SHI, SHLP, and Vistancia advertise that they provide their customers with more than just the "bricks and sticks" of a home and emphasize the features and lifestyle of the community to potential buyers. The costs incurred in their home construction businesses include: (1) acquisition of land; (2) financing; (3) municipal and other regulatory approvals of entitlements; (4) construction of infrastructure; (5) construction of amenities; (6) construction of homes; (7) marketing; (8) bonding; (9) site supervision and overhead; and (10) taxes. Their primary source of revenue from the home development business is from the sale of houses.

SHI, SHLP, and Vistancia constructed their developments in a sequence of stages consisting of: (1) grading land; (2) initial construction of amenity and infrastructure common improvements; (3) construction of homes; and (4) construction and finalization of any remaining common improvements. The amount of time it took to grade the land and initially construct the amenities and common infrastructure varied with the size, surface and subsurface condition, and nature of the development.

SHI, SHLP, and Vistancia charged a single price for their homes. They did not charge separate prices for the home, the lot, improvements to the lot, infrastructure and amenity common improvements, financing, fees, property taxes, labor and supervision, architectural and environmental design, bonding, or any other costs. Before the buyer and seller could close escrow on a home, SHI, SHLP, and Vistancia were required to either construct all common improvement areas for the development (or phase) or post a bond. Therefore, in some instances the buyers were required to pay the full contract price before all of the common improvements and amenities promised for that development were completed.

To monitor operational performance and income tax compliance, SHI, SHLP, and Vistancia divided the total incurred direct and indirect costs by the total budgeted direct and indirect costs. Their tax departments made relevant adjustments to reflect what it considered to be the requirements of Code Sec. 460. If the incurred costs were equal to or greater than 95 percent of the budgeted costs, then the businesses reported income for that tax year from homes that had closed in escrow up to that date. If the incurred costs did not exceed 95 percent, then any income from homes that closed in escrow that year was deferred.

All the businesses use the accrual method of accounting. During the years at issue, SHI, SHLP, and Vistancia used the completed contract method of accounting to defer revenue, costs of sales, and income from sales of homes that closed in escrow. The businesses then recognized part of that income for federal income tax purposes in the following years.

The IRS included in income the amounts SHI, SHLP, and Vistancia deferred using the completed contract method and assessed a deficiency as a result.

Accounting for Long-Term Contracts

Code Sec. 460 governs how taxpayers report income from long-term contracts. It generally provides that taxpayers who receive income from long-term contracts must account for that income through the percentage of completion method. This method essentially requires a taxpayer to recognize income and expenses throughout the duration of a contract. However, home construction contracts are excepted from this rule and, under Code Sec. 460(e), income from such contracts may be accounted for under the completed contract method.

Under Code Sec. 460(f)(1), a long-term contract is any contract for the manufacture, building, installation, or construction of property if such contact is not completed within the tax year the contract is entered into. While the statute does not define completion, which is determined on a contract-by-contract basis, Reg. Sec. 1.460-1(c)(3) provides that a contract is completed when it first meets one of two tests. These tests are commonly known as the (1) use and 95 percent completion test, and (2) the final completion and acceptance test.

Under the first test, the 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 percent 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. In this case, the determination of whether final completion and acceptance has occurred depends on all the relevant facts and circumstances.

Home Construction Contracts

As previously noted, while the percentage completion method is generally required for long-term contracts, there is an exception for home construction contracts. Under Code Sec. 460(e), income from home construction contracts may be accounted for under the completed contract method. Generally, a taxpayer using the completed-contract method to account for a long-term contract must take into account in the contract's completion year the gross contract price and all allocable contract costs incurred by the completion year.

A contract is a home construction contract if the taxpayer (including a subcontractor working for a general contractor) reasonably expects to attribute 80 percent or more of the estimated total allocable contract costs (including the cost of land, materials, and services), determined as of the close of the contracting year, to the construction of (1) dwelling units in buildings containing four or fewer dwelling units (including buildings with four or fewer dwelling units that also have commercial units); and (2) improvements to real property directly related to, and located at the site of, the dwelling units.

Under Reg. Sec. 1.460-3(b)(2)(iii), 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.

Taxpayer and IRS Arguments

For the purpose of determining whether a contract qualifies as a home construction contract, Reg. Sec. 1.460-3(b)(2)(iii) makes it clear that the taxpayer includes, for purposes of the 80 percent test, costs attributable to common areas. However, SHI and the IRS disagreed as to whether that regulation affected the tests that determine when the taxpayer completes the contract for the purposes of deciding whether the contract is a long-term contract.

Under the IRS's interpretation of the completed contract method, SHI, SHLP, and Vistancia should have reported income from their long-term contracts for the years in which the contracts closed in escrow. According to the IRS, the subject matter of the contract is the home and the lot upon which it sits. Consequently, each contract is completed, within the meaning of Code Sec. 460, in the year in which escrow closes.

According to SHI, SHLP, and Vistancia, the subject matter of the contracts is broader and encompasses the entire development or, in some instances of larger developments, the development phase of which the home is a part. In support of that position, they argued 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 purchaser's title. They asserted that these documents collectively set forth the rights and obligations of the buyer and seller. Therefore, other than secondary items if any, the final completion and acceptance does not occur until the final road is paved and the final bond is released. As a result, the use and 95 percent completion test is met first when SHI, SHLP, and Vistancia incur 95 percent of the phase's or development's costs. SHI, SHLP, and Vistancia argued that because the 80 percent test for a home construction contract includes the allocable share of the costs of common improvements, the 95 percent test also must include these costs.

The IRS urged an alternative theory that said that, if the Tax Court held that the subject matter of the contracts is broader than the house and the lot, the court must apply the 95 percent completion test without regard to the costs attributable to common improvements because they are secondary items. However, according to SHI, SHLP, and Vistancia, these common improvements are part of the primary subject matter of the contract, not secondary items, and they may include such allocable costs in applying the 95 percent test.

Tax Court's Analysis

The Tax Court began by analyzing which documents are considered part of the contracts. The court concluded that the purchase and sale agreement did not alone serve as the exclusive embodiment of the entire agreement between the parties. Buyers of homes from SHI, SHLP, and Vistancia, the court noted, are consciously purchasing more than the "bricks and sticks" of the home. The purchase and sale agreement specifically includes a checklist ensuring that the purchaser receives other related documents. The court also observed that purchasers of homes in the developments were conscious of the elaborate amenities and would have understood that the price they paid for a home included the amenities of the development.

Further evidence that SHI, SHLP, and Vistancia were obligated to their lot purchasers for much more than the purchase and sale agreement sans amenities, the court said, was the hefty performance bonds that were required by state and municipal law in order to secure the builder's performance with respect to the completion of the common improvements in each development. For the performance bonds to be exonerated, the obligees had to approve the completion of the amenity subject matter. Homeowners associations in each of the developments, as well as the municipalities and states in which the developments were situated, were identified as obligees in the performance bonds. Purchasers of homes automatically became members in the homeowners association.

The Tax Court rejected the IRS's view that the subject matter of the contract consisted solely of the house, the lot, and improvements to the lot, noting that Reg. Sec. 1.460-3(b)(2) explicitly acknowledges that the subject matter of a home construction contract extends beyond the construction of a home.

The Tax Court also rejected the IRS's contention that the costs not directly associated with the houses, the lots, and improvements to the lots were secondary items under Reg. Sec. 1.460-1(c)(3)(ii) and thus the homebuilders were forbidden from taking those items into account in determining the contract completion date. The court noted that the term "secondary items" is not defined in the regulations and that the determination of what constitutes a secondary item is resolved by reference to the facts and intent of the contracting parties. The court again agreed with the homebuilders' view that because the contracts were about the lifestyle, including access to the planned community, the amenities, and the infrastructure, this meant to the court that the common improvements were part of the primary subject matter of the contract.

The court concluded that the contract documents consisted of much more than just the purchase and sale agreement. This conclusion led the court to hold that SHI, SHLP, and Vistancia appropriately included the costs of common improvements in determining the contract completion date. Further, the nature of the business and the contract documents also led the court to conclude that the common improvements were not secondary items and did not have to be accounted for separately. (Staff Contributor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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