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Tax Court Draws Bright Line on Use of Completed Contract Method by Developers.
(Parker Tax Publishing June 7, 2014)

In 2012, residential land developer Howard Hughes Corporation (HHC) went before the Tax Court to contest a $144 million assessment by the IRS. According to the IRS, the developer's contracts to sell land through bulk sales, pad sales, finished lot sales, and custom lot sales were not home construction contracts and, thus, the developer's use of the completed contract method was improper. Additionally, the IRS contended that some of the contracts were not long-term construction contracts eligible for the percentage-of-completion method of accounting.

In the meantime, while waiting for the decision in its case, HHC had reason to be hopeful because another developer scored a big victory in February against the IRS. In Shea Homes, Inc. v. Comm'r, 142 T.C. No. 3 (2014), one of the largest private homebuilders in the United States 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 homebuilder was able to defer taxes on millions in profits.

Unfortunately, HHC was not so lucky. In The Howard Hughes Company, LLC v. Comm'r, 142 T.C. No. 20 (6/2/14), the Tax Court held that the developer's contracts were not home construction contracts and, thus, gain or loss from such contracts could not be reported using the completed contract method. An important consideration for the court was the fact that HHC did not build homes on the land it sold, nor did qualifying dwelling units exist on the sold land at the time of the sales.

There was one positive note: The court rejected the IRS's assertion that certain HHC contracts were not long-term construction contracts and, thus, HHC was entitled to use the percentage-of-completion method.

In reaching its decision in the instant case, the Tax Court recognized the potential tension with Shea. Its decision in Howard Hughes, the court said, is meant to draw a bright line as to the type of contracts that can qualify as home construction contracts eligible for the completed contact method. As such, 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. In Shea, the Tax Court noted, the taxpayers closed their contracts only after a certificate of occupancy had been issued and simultaneously with the purchaser's taking possession of their house. It is not enough for the taxpayer to merely pave the road leading to the home, the court said, though that may be necessary to the ultimate sale and use of a home.

Practice Tip: In light of this decision, practitioners with clients using the completed contract method may need to reevaluate whether that is the proper method based on the type of sales their clients are engaging in.

OBSERVATION: There is some concern that this decision could hurt the real estate industry just as it is recovering from the real estate crash in the late 2000s. This is because developers starting new projects will not be able to defer as much income as they otherwise might under the completed contract method and thus will have more up-front costs in the way of tax bills.


In 2007 and 2008, HHC and its subsidiaries were in the residential land development business. They generated revenue primarily by selling property to builders who would then construct and sell homes. In some cases, they also sold property to individual buyers who would then construct single-family residential homes. The land HHC sold and still sells is part of a large master-planned community known as Summerlin. Summerlin is divided into three geographic regions: Summerlin North, Summerlin South, and Summerlin West. Each of these three geographical regions is further divided into villages, each of which averages about 500 acres. Villages are further divided into parcels, or neighborhoods, which contain the individual lots. Summerlin is termed a planned community because it involves residential and commercial areas and provides space for attendant public and private resources and facilities.

HHC Sales Contracts

Sales by HHC generally fell into one of four categories: (1) pad sales; (2) finished lot sales; (3) custom lot sales; and (4) bulk sales. In a pad sale, HHC, after dividing the village into parcels, constructed the entire infrastructure in the village up to a parcel boundary. HHC then sold the parcel to a buyer, who was usually a homebuilder. The builder, with HHC's approval, was responsible for the entire infrastructure (such as streets and utilities) within the parcel and subdividing the parcel into lots. In a finished lot sale, HHC also divided the village into parcels. They then further constructed any additional needed parcel infrastructure, divided the parcels into lots, and sold the neighborhoods to a buyer, usually a homebuilder. In finished lot sales, HHC constructed the entire infrastructure up to the lot line. In both the pad sales and the finished lot sales, HHC contracted with homebuilders through building development agreements (BDA).

Custom lot sales were essentially the same as finished lot sales, except that HHC sold the individual lots. The buyers of these individual lots were individuals who were contractually bound to build a residential dwelling unit. The purchase sales contracts required the individuals to agree that they would occupy the home for at least one year or, if the home was sold before then to a third party, to pay additional consideration of 10 percent of the third-party price. Finally, in a bulk sale, HHC sold an entire village to a purchaser. The purchaser was responsible for subdividing the village into parcels and lots and for constructing all of the infrastructure improvements within the village.

Common Improvements

The BDAs, loan agreements, governmental laws, and other legal obligations required HHC to build common improvements in Summerlin. These improvements included rough grading; roadways; sidewalks; utility infrastructure, such as water, sewer, gas, electricity, and telephone; storm water drainage; parks; trails; landscaping; entry features; signs; and perimeter walls. Upon completion of a common improvement, HHC transferred ownership or granted easements to the respective community association or, where appropriate, the municipality. Generally, community associations received some roads, swimming pools, open spaces, and medians, whereas the municipalities received police stations, fire stations, other roads, traffic signals, and street lights.

Some of these improvements were necessary for construction of the dwelling units. The allocable costs attributable to HHC's improvement construction activities exceeded 10 percent of the various total contract prices. HHC designed all the common improvements in an effort to make Summerlin an attractive community. In addition, HHC monitored and maintained approval control over all construction in Summerlin, including construction of the dwelling units.

HHC's Tax Reporting

In 2007 and 2008, HHC used the completed contract method of accounting in computing gain or loss from the contracts for sale of residential real property in Summerlin intended for residential buildings planned to contain four or fewer residential units per building. Under HHC's methods of accounting, each BDA, custom lot contract, and bulk sale agreement was a home construction contract, and they were not completed until HHC incurred 95 percent of the direct and indirect costs allocable to the agreement or contract. At that point, HHC reported gain from the BDAs, custom lot contracts, and the bulk sale agreements.

HHC broke down estimated BDA costs into three categories: (1) direct village costs; (2) regional costs, and (3) finished lot costs. Direct village costs consisted of the cost for the common improvements that benefit only the village that was the subject matter of the contract. Regional costs consisted of common improvements that benefited more than one village. Finished lot costs were the costs that benefit only the neighborhood or parcel in which the finished lots were located.

The IRS determined that HHC was not eligible to use the completed contact method because its contacts did not qualify as home construction contracts. As a result, the IRS changed HHC's method of accounting from the completed contract method to the percentage-of-completion method. The resulting tax deficiency was approximately $144 million.

Before the Tax Court, the IRS raised an additional issue. According to the IRS, the custom lot contracts and the bulk sale agreements were not long-term contracts and, thus, were not eligible for the percentage-of-completion method of accounting. With respect to the custom lot contracts, the IRS argued that HHC did not have a legal obligation to perform the construction activities contemplated by the contracts and, thus, the contracts were not construction contracts. Because HHC was already obligated by statute to complete various improvements (i.e., had a preexisting duty), the IRS said, the obligations were not contractual obligations. With respect to the bulk sales contracts, the IRS said that because HHC failed to prove that it was required to construct anything under these contracts, HHC failed to carry its burden of proving the contracts were entitled to a long-term contract method of accounting.

Home Construction Contracts and the Completed Contract Method

Gain or loss on home construction contracts can be accounted for under the completed contract method. Code Sec. 460(e)(6) defines a home construction contract as any construction contract if 80 percent or more (i.e., the 80 percent test) 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 certain specified activities with respect to dwelling units contained in buildings containing four or fewer dwelling units, and improvements to real property directly related to such dwelling units and located on the site of such dwelling units. The specified activities are defined under Code Sec. 460(e)(4) as the building, construction, reconstruction, or rehabilitation of, or the installation of any integral component to, or improvements of, real property.

Tax Court's Analysis

Percentage-of-Completion Issue

The Tax Court began by rejecting the IRS's argument that neither the custom lot contracts nor the bulk sale contracts were eligible for the percentage-of-completion method. With respect to the custom lot contracts, the court said it was not clear that the preexisting duty rule applied in these cases. First, the contracts between HHC and the purchasers were valid contracts with valid consideration independent of the duties with respect to the development, the court said. Second, while the Nevada statute seemed to grant purchasers a cause of action if HHC failed to construct improvements as shown on site plans or plats, the statute explicitly provides that the civil remedy provided for is in addition to, and not exclusive of, any other available remedy or penalty. Therefore, the court said, it was uncertain whether a Nevada court would apply the preexisting duty rule to HHC's contracts.

The court also disagreed with the IRS argument that Reg. Sec. 1.460-1(b)(2) codifies the preexisting duty rule. That regulation, the court noted, clearly states that "how the parties characterize their agreement (e.g., as a contract for the sale of property) is not relevant" in determining the existence of a Code Sec. 460 construction contract. Rather, the regulation allows a taxpayer to include the allocable costs "if the taxpayer is contractually obligated, or required by law, to construct the common improvement." Nothing in the regulation, the court observed, requires that the contract be the sole source of the obligation, and, in fact, it indicates the opposite - that the obligation may be noncontractual.

With respect to the bulk sale agreements, the court said these are merely pad sale BDAs on a larger scale. The court noted that it had heard credible testimony from HHC's Vice President of Finance that the bulk sale contracts were BDAs and that HHC was obligated to build the same types of common improvements that benefited the property sold, such as regional water lines, traffic signals, and detention basins. Thus, the court held that these contracts were also construction contracts that may be accounted for as long-term contracts.

Completed Contract Issue

The Tax Court held that HHC was not eligible to use the completed contract method. Use of the completed contract method, the court said, depended on whether the HHC contracts qualified as home construction contracts. The issue centered on whether the contract qualifies if the seller does not build the house or any improvements on the lot. There was no disagreement that the structures to be built upon the land sold would be dwelling units.

An important factor in denying HHC's use of the completed contract method was that HHC did not build homes on the land it sold, nor did qualifying dwelling units exist on the sold land at the time of the sales. HHC did not establish that, at the time of each sale, qualifying dwelling units would ever be built on the sold land.

The Tax Court found one particular bulk sale agreement especially troubling, as no construction had yet occurred years after the sale. And, in that case, because the purchaser-builder defaulted on the contract, HHC still owned half of the property. As far as the court knew, no qualifying dwelling units might ever be built on the property, and deferral of income from contracts that might not ever result in qualifying dwelling units seemed entirely inappropriate to the court in these circumstances.

HHC, the court observed, closes the contracts and receives revenue without needing to build a single home. In contrast, the court observed, the taxpayers in Shea Homes closed their contracts only after a certificate of occupancy had been issued and simultaneously with the purchaser's taking possession of their house. In the instant case, the court said, HHC is under no contractual obligation to build homes as their contracts are merely for the sale of land, developed to varying degrees, to builders or individual customers who may eventually build homes on that land.

The court reviewed how Code Sec. 460(e)(6) defines a home construction contract by reference to the estimated total contract costs attributable to construction activity "with respect to" (1) dwelling units and (2) improvements to real property directly related to the units and located on the site of the dwelling units. Moreover, Reg. Sec. 1.460-3(b)(2)(i), the court noted, clarifies that the allocable contract costs to be included in the 80 percent test must be attributable to the construction of the units and the improvements thereto.

According to the IRS, the home construction contract exception requires the taxpayer to actually build dwelling units or to build improvements to real property directly related to and located on the site of such dwelling units.

HHC, on the other hand, argued the statute contemplates a broader definition of home construction costs. Under its interpretation, HHC's development costs are allocable to the contracts and the costs benefit the dwelling units and real property improvements related to and located on the site of such dwellings sold. Thus, HHC contended that the costs were therefore attributable to the dwelling unit construction activity and that these costs should count towards meeting the 80 percent test. Accordingly, Code Sec. 460(e)(6) applied even though HHC did not construct the dwelling units. This conclusion follows, HHC said, because the statute does not confine the availability of the completed contract method of accounting to those taxpayers who build the dwelling units' "sticks and bricks" and/or real property improvements related to and located on the dwelling units' lots.

The Tax Court noted that HHCs' 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. Without HHC's development work, the court said, the pads and lots would be mere patches of land in a desert. Thus, the court found that HHCs' work may indeed be necessary for the ultimate home to feasibly be built and occupied. But these correlations, the court concluded, do not mean that those costs are necessarily incurred "with respect to" qualifying dwelling units. According to the court, "with respect to" implies a stronger proximate causation than HHC's interpretation permitted.

Ultimately, the Tax Court rejected HHC's interpretation and concluded that none of HHC's costs were attributable to the construction of the dwelling units because HHC did not intend to build such units, and neither the units nor the real property improvements related to and located on the site of the dwelling units had yet been built. (Staff Editor 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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