The Tax Court has found that a developer of planned residential communities could use the completed contract method (CCM) of accounting under Code Sec. 460. The subject matter of the home sales contract included the improvements and amenities of the entire development, not just a house and the lot on which it sat.
Congress has acted to limit the use of the CCM and to generally require taxpayers to account for long-term contracts by using the percentage of completion method. However, there is an exception for home construction contracts. The Tax Court’s decision turned on whether the “contract” meant the contract for each individual home or included improvements that were part of the planned development as a whole.
The Tax Court’s decision enabled this taxpayer to defer significant amounts of income for an extended period. In a footnote, the court cautioned that the analysis of the issue depends on all the facts and circumstances regarding the subject matter of the construction contract.
The taxpayer was a developer of planned residential communities. The developer purchased land, constructed infrastructure and amenities as common improvements, and constructed homes. Taxpayer marketed the community and the life-style of the development, not just the individual home itself.
The taxpayer charged a single price for each home; this price included a share of the costs for land, common improvements, and the house. The costs for improvements and infrastructure were 27 percent or more of the total budgeted costs. If the taxpayer incurred 95 percent of the budgeted costs, the taxpayer reported income from homes that had closed up to that date. If costs were less than 95 percent, the taxpayer deferred income from any homes that closed that year.
Before the buyer and seller closed on a home, the seller was required to construct all common improvements or post a performance bond. At closing, the developer had paid all costs to construct the dwelling and improve the particular lot. The purchase contract referred to various documents setting out the features of the development, including a progress report and a declaration of covenants, conditions and restrictions regarding the use and enjoyment of the purchased property. Each development had a homeowners association to enforce conditions and manage the development. Upon closing, the purchaser became a member of the association.
Code Sec. 460
A long-term contract is a contract to build, install or construct property that will not be completed in its initial tax year. The regs provide that a contract is completed upon the customer’s use of the “subject matter of the contract” and at least 95 percent of the costs of the contract’s subject matter have been incurred. The cost of incomplete secondary items is disregarded.
The CCM is available to home construction contracts. These are contracts where 80 percent of the estimated total contract costs will be attributable to dwelling units and to real property improvements related to and on the site of the dwelling units. The regs include in the cost of the dwelling units the allocable share of costs for common improvements (sewers, roads, clubhouses) that benefit the units and that the taxpayer is obligated to construct.
Arguments and analysis
The taxpayer deferred hundreds of millions of dollars in income for the years at issue and recognized the income over several subsequent years. The taxpayer argued that the subject matter of the contracts was the entire development, and that completion did not occur until the final road is paved and the final performance bond is released. The 95 percent test would not be not met until the developer incurred 95 percent of the development’s costs.
The IRS argued that the taxpayer had to report income from its long-term contracts for the years that the individual home contracts closed. Each contract was completed when the escrow closed, and there is final completion and acceptance of the individual contract, the IRS claimed. Alternatively, the IRS argued that common improvements to the developments were secondary items and that these costs should not be counted in applying the 95 percent threshold.
The Tax Court concluded that, based on all the facts and circumstances, the subject matter of the contract was the entire development, and that the developer was obligated to provide amenities and infrastructure as part of the contract. The regs under Code Sec. 460 acknowledge that the subject matter extends beyond the construction of the home, the court found. Relevant contract costs include the cost of any activity necessary for the taxpayer’s performance. The taxpayer was entitled to defer income from the home sales contracts until 95 percent of the total contract costs are incurred.
The court also found that the amenities and infrastructure were not secondary items and that their costs had to be considered in applying the 95 percent test. The taxpayer’s accounting method also clearly reflected income under the CCM.
If you have any questions regarding this case and its impact on you specific situation, please do not hesitate to contact us.