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Tax Court’s Disparate Opinions on Home Building Deferrals Requires Careful Planning for Contractors
The construction industry has unique federal tax accounting methods for real property improvement projects. Specific options vary by builder size and contract type, and the differences are often substantial. Commonly employed methods include both cash and accrual, as well as percent complete and completed contract methods. While the completed contract method is permitted in relatively narrow circumstances, it can serve to defer all profits of a building project until the entire job is finally completed and accepted.
The benefits of the completed contract method are clear. In the custom homebuilding industry, for example, where the completed contact method is commonly available, the builder recognizes neither revenues nor costs until the home is finished. This permits the measurement of taxable income when the project is complete and all of the revenues and costs are known with certainty. This is true even if the construction process begins in one year and spans into the next (or even several subsequent years). The effect may be a sizable income deferral since no profits at all are recognized in the year(s) before completion. This even works in cases where the cash flows have allowed the construction contractor to pocket the lion’s share of the financial benefits of the project before the job has ended.
Completed contract accounting is generally allowed for qualified projects involving single-family homes or structures with as many as four dwelling units. Housing builders have found this an attractive method of income recognition. Some larger developers have cleverly engaged in contracts that cover not just a single home, but whole neighborhoods or even entire planned communities. They argue that the structure of the law allows a deferral under the completed contract method until the entire development is complete. For some developments, this could be dozens of years.
Tax court turnaround
Not surprisingly, the IRS is not a fan of long-term completed contract deferrals. It has systematically pursued developers using these aggressive contracting strategies both in audits and in court. During 2014, two important cases addressed these techniques.
One was a win for taxpayers, adding credibility to deferrals. The other suggested limits to the technique. Early in 2014, the United States Tax Court ruled in Shea Homes Inc. et al. v. Commissioner (142 T.C. No. 3) that a residential developer was qualified to use the completed contract method on home construction that spanned large phased neighborhood projects. Surprisingly, the same United States Tax Court — in an opinion written by the same judge — reached the opposite conclusion a few weeks later in Howard Hughes v. Commissioner (142 T.C. No. 20), basing its opinion on a conclusion that the contractor was not, itself, subject to a contract to build homes.
Careful tax planning required
To reconcile the two cases, it is useful to view the disparate opinions in light of the specific contracting terms applicable in each case. From the subtle factual differences of each case, very different tax results arise.
“This is a great example of how effective the right tax planning can be,” says John Dorn, construction and real estate tax principal with CliftonLarsonAllen. “The right application of the law and contracting structure makes all the difference in the timing of tax obligations and, ultimately, the financial risks of a project.”
The Howard Hughes opinion shows the court drawing a bright line in which a “taxpayer’s contract can qualify as a home construction contract only if the taxpayer builds … or installs integral components to dwelling units or real property improvements directly related to and located on the site of such dwelling units.”
The court distinguished between taxpayers involved in home building and “land developers who do not build homes.” Going forward, housing development planners will have to make sure to explicitly structure their home construction contracts so they can take advantage of the completed contract method. Home builders and project developers can find added strength for their positions in light of the Shea decision, but they need to follow the requirement to build integral components to dwelling units or directly related real property improvements.
How we can help
The resurgence of homebuilding activity makes this an excellent time to consider not just the potential for development but the benefits of solid tax planning. CliftonLarsonAllen professionals offer thoughtful insights on how to manage the tax and compliance responsibilities of homebuilding projects.